Wednesday, January 4, 2012

The Complexities of Pricing

How do merchants price items?  Why are they offered 'on sale' sometimes?  Why are rebates and discounts offered?   The answers are very complex.

In basic consumer economics, people miss the point that retailers discount prices to do one thing: sell products.  And when they discount prices, oftentimes this is a sign the product is not desirable in the marketplace.  Or the discount is a phoney discount from a price the product never sells for.

Pricing of a product is not an exact science.  Many people actually believe that there is a "price" on everything, and that price is handed down from God himself.  Or they think the merchant carefully adds up the cost of making and selling the product, adds on a "reasonable profit" and then sells at that price.  Guess again.

The real answer is that prices are determined by the market, and retailers get what they can get for what they are selling.  If a product is popular, they raise the price.  If it stinks, they lower the price, substantially, to move it out the door.

And a lot of inferior products get sold this way, too.  Before you look at a product for which there is a sale price, or rebate, think about this carefully.   Are they lowering the price to move a substandard product?  Or perhaps they are not lowing the price at all?  Maybe their "lower price" is the real price, and the "suggested retail price" is just a made-up number.

The following are some commonly held beliefs about pricing.  And in the abstract, they sound silly.  But chances are, at least subconsciously, you've held these beliefs at one time or another - I know I have!

1.  They are offering a rebate or sale price as a favor:  No, really, people actually believe this.  "We're celebrating our 10th anniversary, and as our gift to you, everything is on sale!"  People actually think that companies are kind-hearted and want to see you get ahead, so they are holding a sale as a thank-you to consumers!
2.  They are offering a rebate or sale price to get you to try a product:  No, not really.  When a product doesn't sell well, they cut the price.  You lower the price, product moves.  They are not interested in trying to "win you over" to a shampoo or detergent brand.  They just know that your price point is below their nominal price, and that they can move product if they offer it to you at your price point.
3.  They are offering a rebate or sale price to move out product at the end of the model year to "make way for the new models!":  No, again.  A popular product sells out, and there is no "leftover" at the end of the year, unless the leftovers are the undesirable versions (the brown car with green interior).
4.  At certain times of the year, such as President's day, they lower prices because, well, prices are just lower then, that's all!  The day after President's day, the cost of a car increases mysteriously.  So you'd better sign the papers on that deal today or lose out forever!  If you can't see this transparent attempt to pressure you, forgetaboutit! 
5.  The sale price is really a lower price that what others ordinarily pay:  The car makers have really shot themselves in the foot with this one.  No one pays "sticker" price on a car anymore.  And while some car makers are more realistic about sticker prices, they still are just placeholders and not actual prices.  When someone offers you "$10,000 off!" a new pickup truck, you have to come to the conclusion that the sticker price is a sad joke.  No, the "sales price" is no great bargain, just closer to what you should expect to pay for the commodity.
Pricing is a very interesting and complex thing that seems deceptively simple.  Many folks think that it involves little more than simple mathematics, when in fact, serious Calculus is involved.  The retailer wants to get every last penny from each consumer - selling to each consumer the product at the highest price they would pay.

And that is why car prices are so flexible, and why there are rebates, coupons, and other gimmicks out there, designed to get people who ordinarily would think a product is "too expensive" to buy that last marginal quantity.

Does this mean you should shun sales prices, rebates, or coupons?  Again, don't be reactionary, it really annoys me.  No, what this means is that you should look at these things with a jaundiced eye.  Are they trying to entice you to spend-up by offering an apparent discount?  Are they touting the "savings" more than they are the price?  Are you buying something that you don't need or want or would otherwise buy, but for the fact it is "on sale" or has a rebate?

And oftentimes we buy this way.   At the wholesale club, you see a big box of consumer goods at a ridiculously low price - so you buy it.  "At this price, how can you afford not to buy it ?" is the battle-cry.  But if you don't need it, even if it is only 50 cents, it is 50 cents you wasted.

The mall works the same way.  A couple of years back, we went to the local mall with a friend (haven't been back since) and we bought a pair of pajama bottoms - marked down from $70 to $12!  Now, think about this for a minute - who buys pajama bottoms for $70, made of cotton?  Silk, maybe I could see the whole set.  But a pair of cheaply made pajama bottoms from China?  $12?  They still made $10 on the deal, if not only $5.

And that was a good lesson for me.  We bought them not because I needed them (I have a drawer stuffed full of this kind of stuff) but only because it appeared to be an apparent bargain and it appeared to be a small amount of money.   But $12 is twelve bucks, and if you spend that way, it becomes a hundred bucks, and over time, intractable credit card debt.

Or take the wine I bought at the wholesale club the other day.   Yea, I got roped into the "instant rebate" deal on the wine.  I bought two bottles of wine that I might not have considered, because it was labeled with "instant rebate" coupons, and that caught my eye - and my subconscious.  Here was a chance to get a $9.99 bottle of wine for $5.99!  (inexplicably, the cash register rang up the $4 off coupon, twice).  I was getting an upgrade!

Well, probably not.  I bought a $5.99 bottle of wine, plain and simple.   And if the price goes back up to $9.99, I probably will buy other, cheaper wines instead.  They have a good Argentinian Malbec blend for $4.99 every day.  Why pay more?

And in fact, these come-ons can backfire for retailers.  If I was looking for a $9.99 bottle of wine (which I am wont to do) I might buy that bottle, at the $9.99 price, perceiving it to be a little better quality, something to serve to the neighbors at supper.  But since I've had it for $5.99, my perception of it might change.  And when they remove the promotional pricing, I may be more inclined to view it as "overpriced $5.99 wine" rather than "a good $9.99 wine".

Pricing of a product is anything but simple - it falls within the intersection of mathematics, algebra, calculus, differential equations, advanced psychology, group psychology, and even quantum theory.  Just picking a price point for an article is a major science, not some off-the-cuff calculation.  Books have been written on this stuff.  People do their PhD. dissertations on it.  People make careers in it.

And here we are, lost sheep in the marketplace, thinking we can outsmart them by getting a 'bargain'.

And this is just for basic pricing.  Once you throw in the complexities of coupons, rebates, instant coupons, reward cards, loyalty cards, flyer miles, BoGos, and other promotions, well, the complexity of pricing rises by an exponential factor.

So, how do you, as a consumer, who likely didn't take much math in High School (and didn't do well at that) deal with all this?  Well, first of all, you do, in a remarkable way - the brain is a complex neural network that can be programmed, or more correctly trained to solve incredibly complex problems.  It is, in fact, your secret weapon, if you chose to use it properly.

The housewife who navigates the supermarket and seeks out the best price on soap may be solving some third order differential equation in her brain, without even knowing it.  And one way she "trains" on this is through trial-and-error.  The bargain brand soap may seem appealing, but provides fewer loads of laundry.  The premium brand gives more loads, but at a higher cost-per-load.  Through trial-and-error (training the neural network) she settles on the optimal outcome, which may be a middle-priced brand.

And this illustrates why it is so, so important not to be afraid to make mistakes and to make mistakes  and learn from them.   Your neural network learns nothing from risk-avoidance and learns even less from denial, blame-shifting, or externalizing your problemsTrain your brain and it will serve you well.

But of course, our friends in the marketing department hate this.  They would rather reprogram your brain with some poor normative cues - these are skewed weighting factors for your network nodes that will alter the outcome of your thinking.  And oftentimes, you only have to "tweak" the weighting factor of a node or two, to change a purchasing decision or brand loyalty - or political affiliation.

So they try to trick you, with a lot of distracting noise and bullshit like coupons and rebates, and come-ons.  They want you to stop thinking about the basic transaction and go chasing after more complicated deals.

And that is where you have them, right there.  Go for the simpler deals, and 9 times out of 10, you come out ahead.  The regular bottle of wine for $5.99 is a better wine and a better deal than the $9.99 with the $4 rebate gag.  The more complicated deal is not a better deal, even if on its surface appears to be a savings.  But it is not.

But how can you get simple, basic deals, in a world chock full of rebates and loyalty cards?  It isn't easy, but it can be done.

For example, Nissan was offering a $2000 rebate on its Frontier 4-door pickup truck, which put it at an attractive $21,500 price, nicely loaded, at the volume dealer in Savannah.  But, now that sales are up, and the recession is "over", the rebate is gone, and now the truck is selling for $23,500.  What happened in six months to make the truck cost 10% more?  Nothing, other than demand went up.

And this illustrates why merchants keep prices flexible, so they can adjust them to meet supply and demand.  It is much easier to offer a "rebate" than to adjust sticker prices on all the trucks in the lot. Besides, people get pissed off when you raise prices.  And a rebate allows you to alter the price on a product, once it is already in the product pipeline.

So how do you avoid this game?  Look for the same vehicle, about 1-3 years old, with low miles, for sale from an individual who garaged it, changed the oil, and kept all service records.  They are out there, but few people look for them (no really, most idiots march off to a used car dealer instead!)  The overall cost could be 20% less or more.  By the time the vehicle is 5 years old, perhaps 50% less. And the overall cost-per-mile is a lot less than buying brand new.

And a lot of this has to do with the fact that you are not drawn into the horrendous pricing games that retailers like to play.  When dealing with an individual, there are no rebates to deal with, no coupons or cash-back.  If there were, you'd think that was pretty freaky, wouldn't you?  So why do you accept this as the norm at a retailer?

Of course, not buying at all is even a better option, and in the overheated car market of the last three months, sitting it out might be a good idea.  When everyone decides to buy, prices are not their best.  Wait for a lull in the market, before buying.

But it is interesting, is it not, how we are all herd animals?   In March of 2011, you could not give away a new or used car.   But in November of 2011, they are in high demand.  Is traveling with the herd going to get you the best deal possible?

Likely not....