Let's Talk Price: An Economist's Method

When buying something, PRICE is a big deal. You can't escape the fact that all people, customers, companies, Governments, are stingy and don't want to part with their precious dough when paying for something, but at the same time everyone wants to charge the most when selling something (negotiating salaries, eBay auctions, etc). You must consider that raising prices to $XYZ limits your appeal to the amount of possible consumers that can afford to part with $XYZ, regardless of how valuable, fashionable or delicious your widget is.

So consider the following graph:

The red, downward-sloping line represents a typical demand curve. On the Y-axis (up and down) is Price, and the X-axis (left to right) are the units sold. So imagine you price your product somewhere on this demand curve; will you price low to attract the masses of consumers or price high to achieve an attractive profit margin on each unit sold?

Hopefully you're thinking to yourself, "Maybe somewhere in the middle where I can get a decent margin from a fair sized customer base."

A gold sticker if you were thinking this, no points for second place.

The optimal sacrifice of high prices and high customers occurs when the projected revenue curve is at its apex (highest). In the case above, it is at $20, with 6000 units being sold. Any price above or below this will offer less revenue. Ok great, but is revenue our objective? Sure boasting a revenue report doubling your closest competitor may put a feather in your cap, until your accountants tell you that you've sold everything under cost and you've got the financial head hunters sharpening their blades for a clean scalping.

This is hardly the case but it can happen. Revenue is a myopic approach to pricing goals. The goal should be to maximise profits not revenue.

Profit = Revenue - Cost of Goods Sold

A+ if you were already on this train of thought when I was discussing revenue, again, no points for second place.

Total cost can be expressed as the summation of an overhead or fixed costs (costs that are independent of how much or little you produce, such as rent, interest on debt, salaries of full-time employees) and variable costs (costs that are dependent of production like raw materials and labour) which forms an upward sloping cost curve. But to ascertain the most efficient level of production, average cost must be quantified.

Total Cost = Fixed Costs + Variable Costs

Average Cost = Total Cost ÷ Units Produced

So let's assume you're production plant for widgets is fitted out to reflect the following average cost curve:

The average cost curve takes this shape because it is most efficient at producing your widget in a certain zone inbetween declining economies of scale and increasing diseconomies of scale. So in this instance, this plant should aim to produce at most [5600 to] 7400 units.

Ok so I've been going on about COST, but what we really want to know is how to maximise PROFIT. So just subtracting the Total Cost Curve from the Total Revenue curve will represent a Total Profit curve. From this stage, you should only produce at the point where profit is the highest, which is 5000 units.

This level of production is actually below the production plant's optimal range and also lower than the maximum potential revenue. So as a medium-long term goal for capitalising on profit, you may look at (i) adjusting the plant's production capabilities to become optimal at a lower range, or (ii) chemically brainwash consumers to encourage them that they need more widgets. I'd go for the second option.

Now here's the trouble when you do this in the real world: You don't know what the demand curves are like, and only have some idea or control of your production capabilities and efficiencies. What you have to do is try to achieve the best results from whatever hunches or incomplete information you have available.

Coca-Cola: Queching a Heirarchy of Needs

The American psychologist Abraham Maslow is ranked in the top tier of the 20th Century's thinkers, mainly because of his model: The Hierarchy of Human Needs. He may not be as witty and memorable as Sigmund Freud, but this model does carry on from Freud's work on the Id, Ego and Super-Ego, and is widely accepted in the schools of health and economics.
The Hierarchy of needs is illustrated as the figure below:

Any rational human being will follow this model when fulfilling their various needs. On the first level are physiological needs; these being needs that we physically require for survival: Air, food, water, sleep, clothing, sex, et cetera. So regardless of how much we want to save the whales or write blog entries that will most likely never be read, published or recognised for their literary genius; if our human bodies are not sated with its physiological needs, we will simply wither and die.

So once this level of needs are sated, needs revolving around safety and security become top priority, followed then by love and belonging, esteem then self-actualisation. Remember that you will only pursue the satisfaction of higher level needs once all of the lower level needs are achieved.

But...

Everyone is different. The level of satisfaction for sexual intimacy, for example, will differ depending on how an individual values sexual intimacy. One person will yearn for a long-term, highly involved sexual relationship with another, whereas another may be completely sated with a purely platonic affinity with another, or value a life of celibacy. Crazy, I know...

In a nutshell, the higher up you move in the hierarchy, the more specialised, complex and intangible the needs become; focusing on the higher order demands of your personality and ego. The highest level of needs is self-actualisation. This can thought of as striving for personal growth, development and self expression.

So think about the things you value and which you could classify as fulfilling or enhancing a particular human need. You should be able to connect many brands, products and services with lower level needs compared to those above them. Right?

For example, to satisfy your physiological needs for clothing during these cold Sydney Winters, you could just take a trip to your local Salvo's for a jacket, and that would be fine. But to also fulfill your requirements of safety and security, you would probably want to take a trip to the local shops with better quality clothing so you can feel assured that the clothing is more suitable (proper fitting, acceptable returns policy) and that it will perform well. Furthermore you may want to peacock a bit and let the world know that you exist. Rather than going anywhere cheap and local you decide to take a trip to David Jones or any high-end retailer for something fashionable, more expensive and recognisable. You will conform to what is the norm and gain respect and acceptance (in the fashion world at least) as well as project achievement and confidence, fulfilling your esteem needs.

But if that wasn't enough for a jacket, if you can afford it (or have adequate credit limit) you want more. You value your jackets and your body being kept from wind chill as well as being fashionable but... You want a Burberry trench coat (at least AU$1000 when they're on sale). You want and need it not because its fashionable and functional, but because you have an emotional connection with it, and owning and wearing a Burberry trench coat doesn't just make you happy, but defines your character - it's somewhat symbolic of who you are - fulfilling self-actualisation needs.

And if you think this is completely stupid, you're probably sharing the same opinions with many others but you're probably doing the same. Ever wonder why people drive Ferrari sports cars? Wear Rolex watches? Collect and seldom wear designer stilettos or elaborate handbags? It isn't because they're "wankers" or infected with consumerism, it's because these people have an emotional connection with what this brand or product represents.

This is a great example: Coca-Cola.

Why would you buy a bottle of Coke which retails at around $2.80 in a supermarket to $6 at the Easter Show, when you can get something like Pepsi which is marginally cheaper, or any other generic brand (such as Aldi's GT Cola) for less than half the price? It has been thoroughly tested that Pepsi trumps Coca-Cola everytime based on taste - I personally prefer the "zing" to Coke than the over-fizzy sweetness of Pepsi - which is why in the USA in 1985, they released New Coke: Same packaging, different taste.

Total Failure.

What they didn't realise was that people had this emotional connection with the original recipe, the brand, and its image and had it at top-of-mind as well as willing to pay the marginal premium for it. Any type of new formulation or radical changes to the packaging and image was [and still is] considered sacrilige; which resulted in New Coke's failure. Coca-Cola is a perfect example of a product that serves no physiological benefits, holding high preference over other brands because it is able to serve the higher order needs of esteem and self-actualisation.

Just recently Vegemite medelled with their [almost Century old] recipe for the new generation of Vegemite children and are currently holding a competition to name the new product. Just from an operational standpoint, I don't really like the idea of two products so similar in mass appeal and production; it just kills Kraft's level of operational excellence... but anyway as a marketer I don't like this move. I'm predicting a like outcome as New Coke - but in the meantime I've submitted an entry for the new name: Vege-a-Boom!