Inflationary times can enable companies to review their entire pricing strategies. But before rushing into price hikes, executives should first reflect on some key underlying points about customer psychology that also apply in times of inflation.
Doug Ivester, the former Coca-Cola president and chair, was once challenged about price fairness. Asked about rumors of a vending machine whose prices would change according to the weather, he replied: “Coca-Cola is a product whose utility varies from moment to moment. In a final summer championship, when people meet in a stadium to have fun, the utility of a cold Coca-Cola is very high. So it is fair that it should be more expensive. The machine will simply make this process automatic.”
The group had no concrete plans for such a device, although it clearly may well have existed in the labs. But after a global outcry from consumers and media, it was forced to deny any such initiative.
The episode may seem odd today amid ready acceptance of price discrimination (known more benignly as “yield management”) among airlines, hotels, and some tourist attractions. Behavioral economics suggests the perception of fairness is often related to the customer’s concept of a “reference transaction”, in turn central to the theory of “dual entitlement” (Kahneman, Knetsch, Thaler, 1986). Dual entitlement suggests customers feel entitled to a fair price. They also acknowledge the firm, or vendor, is entitled to a fair profit.
Three principles are essential to perceived price fairness (Urbany, Madden, Dickson, 1989). First, raising prices to maintain profits is perceived as fair. Second, raising prices to increase profits is perceived as unfair. Finally, maintaining price despite a cost decline (leading to increased profits) is considered fair, since customers will continue paying the price they feel entitled to.
Note also that customers are more likely to accept a discount reduction than a price increase. Economically, it’s the same.
Various scenarios have been tested to determine consumers’ perceptions of fairness. Price rises were considered unfair, for example, if a seller abused its pricing power in a shortage. The sense of unfairness is exacerbated if a firm uses its power not vis-à-vis one customer, but to exploit one customer in a specific situation – say when a landlord increases the rent upon learning the tenant has a new job closer to home.
What does all this mean for pricing policy in inflationary times? The practical implications are straightforward. When you increase prices, the best justification is by highlighting cost increases (although never lie). Note also that customers are more likely to accept a discount reduction than a price increase. Economically, it’s the same. But psychological perceptions are different. Loss aversion dominates.
Price rises can also be masked. So, try to avoid raising prices when the product remains identical. Creating “new” (if similar) products with new prices allows the establishment of new reference transactions. Finally, if a company uses its pricing power (as a monopolist, for example) to increase prices, customers may perceive this as unfair. The more choices they have, the less unfair it will seem.
Before raising prices because of higher costs, companies should seize the opportunity to recalibrate their overall pricing strategies and improve their organizational pricing capabilities. Cost linked to the effect of inflation is only one of the four Cs that determine a company’s optimal prices. Executives should first update their insights on the other three: customers’ willingness to pay, competitors’ prices and offerings, and capacity constraints.
Even if organizations know the optimal price, they are often ill equipped to execute a coherent pricing strategy in the relevant markets. To do this successfully, they must acquire and interpret meaningful customer and competitor insights related to willingness to pay. They also need to analyze the pricing economics of the organizations, and price elasticity in relevant markets.
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