Ahhh, economics. The dismal science.
The problems with economics are many. It’s not an observation of immutable natural law like physics or chemistry. Nor does it heal the sick like medicine. Heck, it doesn’t even inspire or entertain like literature or music. Perhaps that’s why it’s the black sheep of the Nobel Prize family… whereas Physics, Chemistry, Medicine, and Literature have their respective Nobel Prize in ______, economics has The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, named as if Nobel were posthumously trying to distance himself from the field and could only barely tolerate his name being tacked onto the prize at the very end.
Okay, it’s easy to make fun, but I do it from a warm heart. I love economics, or at least, what economics has evolved into over the last several decades as the field began to question one of its oldest, most defining, and most impractical assumptions. They say beauty is in the eye of the beholder, so let’s behold some history and see whether you think it’s lovely or ugly.
See, classical economics tends to assume rational agents, operating with perfect logic to maximize their value from an economic system. There’s even a name for this concept – Homo economicus – the Economic Man who behaves with flawless rationality to optimize his outcomes.
To paraphrase from the sage wisdom of the flop 2002 kung fu parody Kung Pow:
I’m sure on some planet your assumption is impressive. But your weak link is: This is Earth.
Real people don’t always behave rationally. Even when doing so is fairly simple. We had a phenomenal example of this in JC Penney’s change to pricing strategy in 2012. Remember that? They ditched the fake “sales” and went with “fair and square” prices, where they simply listed a regular price instead of the same price listed as a “sales price” against the inflated “normal value.” Sales plummeted, and they abandoned the strategy. Homo economicus would not care whether a $10 shirt was on sale from $40 or whether it was always just a $10 shirt. But Homo sapiens looooove a deal. Brand value and loyalty, pricing and marketing strategies, and much more of those business “tricks” exist because humans aren’t purely rational. Studying them as if they are is foolishness.
From this realization, the field of economics started to evolve. It took some inspiration from psychology, sociology, and neuroscience, and put the “human” back in economics, morphing into behavioral economics. It creates the same kinds of economic models as the classical version of the field, but makes some adjustments so that the models work for humans as opposed to emotionless robots.
Why in the world am I telling you this? Let’s step back a minute and take a question I received from a reader:
A question regarding the revenue, income and cash flow and the customer… at what point does the customer point to these numbers and say “enough is enough” and ask for discounts on the product we supply?
There seems to be a happy medium where you are keeping the investors happy, but still keeping customers happy with acceptable prices for your product. Not sure if there is a universally accepted sweet spot. Maybe the answer is not quite that simple.
-Dustin Tireman
Good question, Dustin. I’ll give you the simple, classic econ answer, and the more nuanced, completely unscientific, Travis’ behavioral econ answer and let you decide what you prefer.
Classical economics would basically have a chart for you to build or reference. It might be complicated, but it would tell you the exact optimal price to hock your product at. Something like this:
Yawn.
These kinds of things have their uses, conceptually and practically. But it’s not the final, “real” answer in the real world that we occupy. With physics, you can break out a calculator and determine how far a ball will fly or how much weight a pulley can lift if you have enough information. Business is messier. It’s both the beauty, and the curse, of business studies. There isn’t an equation to give you an exact answer.
That isn’t to say there’s not a strong, rational component. Our customers can calculate the cost of buying our product from us versus making it themselves. If we can sell a product for $100 and make a $90 profit, but it would cost our customer $500 to make it themselves, that’s an easy sell. They don’t care about our 90% profit margin, because it’s still an 80% discount to the alternative.
But that’s where the human side comes in. If they know that we make 90% profit margins on what we sell to them, they’ll raise an eyebrow. They’ll know it’s possible to do it much cheaper, and they might invest in the ability to make their own stuff or look for another company to buy from at a lower price.
What could we do to avoid that? Well, we could adjust our prices to a lower margin, sure. We could also prevent them from knowing exactly how much profit we get on those products. One way to do that would be to aggregate products across the business into a more central margin, so that the whole picture looks more equitable. We might still sell some products at a 90% margin, but if the customer is happy paying that, and across our entire business they see a fair margin, say 12%, they won’t dig into it. This creates the tug of war between information we legally have to disclose to shareholders and information we will absolutely never disclose. Corporate margins that include a rollup of all programs, we have to publish. But we will never publish margins on a specific program or product if we can avoid it, because it open the window for that critical eye to whittle our profits down.
And doing this is not deceptive. Every time you go to the store, you know you’re paying a profit premium. Whether you buy a pair of pants, a bag of oranges, a car, a television, you know that you’re paying some company more than they paid to make that. But if you think it’s a fair price for whatever reason, rational or otherwise, you’ll buy it. If not, you won’t. Win-win.
So, the “behavioral” answer to optimal pricing in the real world isn’t so much an equation or a chart (though they may be helpful), it’s more conceptual. Your price should be:
- Greater than the minimum amount you would be willing to do business for
- Less than the amount that would piss your customers off enough to walk away
The grey area in between? That’s business.
Beautiful? Ugly? I’ll leave that for you to behold.