Ask the Expert – Episode 2 – Using Cost Argument to Push Price Increases

Prices of commodities from sugar, wheat, cocoa to cotton are on the rise. Brands from Starbucks to Sara Lee to garment makers are starting to state their intention to pass on cost increases to customers. In a recent interview, CEO of Kroger, David Dillon said this about this cost argument made by brands,

I don’t see [rising manufacturers’ prices] as a problem for us. It is a problem for them

Since costs are irrelevant to pricing,  cost increases relevant to price increases?  Is David Dillon correct or should brands use this opportunity to pass on the cost increases and gain pricing traction? As part of my “Ask the Expert” series, I posed this question to William Poundstone, author of several books, including his latest, Priceless: The Myth of Fair Value. He blogs at Priceless-Blog. When I read his book and listened to his NPR interview I felt he took consumer perspective on pricing and it is very interesting to see his detailed response that is backed by behavioral economics research.

Brands from Starbucks to Jenny-O are using cost arguments to push price increases – Should commodity cost increase be passed on to customers?

Yes. Behavioral economics has demonstrated that people do accept the need for sellers to pass on their own increased costs. 1984 was “the year that behavioral economics began,” according to psychologist and Nobel laureate Daniel Kahneman. He and two economists, Jack Knetsch and Richard Thaler, became interested in “fair” prices. The term “fair” has no meaning in standard economics. Yet it’s a word that we all use. Listen to any negotiation, from a used car sale to a corporate buyout, and you’ll hear someone earnestly insist: “I only want what’s fair.”

Kahneman’s group set out to uncover the unconscious rules of fairness. There was then a Canadian public works project that hired college gradates to conduct nationwide telephone surveys. Kahneman, Knetch, and Thaler began supplying the survey-takers with questions about prices and fairness. One of their most famous hypothetical scenarios ran like this:

“A hardware store has been selling snow shovels for $15. The morning after a large snowstorm, the store raises the price to $20.”

The Canadian public was asked simply whether they considered this “fair.” Eight-two percent said no.

There were many other questions along this line, in a which merchant raised prices to reflect low supply, high demand, or both. The public reaction was always the same: It was unfair for a merchant to profit from the most basic free market forces. As Kahneman, Knetsch, and Thaler wrote,

“Conventional economic analyses assume as a matter of course that excess demand for a good creates an opportunity for suppliers to raise prices, and that such increases will indeed occur. The profit-seeking adjustments that clear the market are in this view as natural as water seeking its level — and as ethically neutral. The lay public does not share this indifference.… the gap between the behavior that people consider fair and the behavior that they expect in the marketplace tends to be rather small.”

As a “man bites dog” story, this finding has gotten much publicity. It’s even led to a certain cynicism about behavioral economics among businesspeople. People are irrational, the message seems to be, so what can you do? Actually Kahneman’s group had a number of results that were less surprising but no less important. They found that the public did not automatically reject any price increase as unfair. In particular, the public was willing to accept price increases when the seller was passing on his own increased costs.

It’s therefore a sound psychological strategy for a company experiencing commodity cost increases to use that to justify a price increase. Of course, it’s necessary to communicate the reason through signage, ads, or other means. During the recent egg recall, prices for unaffected and organic eggs went up. This could be seen as raising the price of snow shovels after a blizzard. But my supermarket had a sign explaining that the store’s suppliers had raised their prices, and thus the market had to pass on its cost increases. This transferred any sense of unfairness to the middleman.

That’s important: No one wants to do business with someone who’s not being fair.

One further point: Don’t assume that the public understands inflation. One of the findings of Kahneman’s group was the public consistently fails to take into account changes in the buying power of the dollar. In one survey it was, for instance, “unfair” for a company to cut wages 7 percent (during a time of no inflation), but it was okay to give a raise of 5 percent during a time of 12 percent inflation. Of course, the workers’ buying power is cut by about 7 percent in both scenarios.

A company that hasn’t raised its prices in a few years may feel it’s overdue for a price increase, and no justification is necessary. But the public won’t automatically see it that way. Even a simple inflationary adjustment may need to be justified—and a psychologically savvy way to do it is to cite increased commodity costs.

—William Poundstone
See also:
Kahneman, Daniel, Jack L. Knetsch, and Richard Thaler. (1986). “Fairness as a Constraint on Profit Seeking: Entitlements in the Market.” The American Economic Review 76, 728-741.
Kahneman, Daniel, Jack L. Knetsch, and Richard Thaler. (1986). “Fairness and the assumptions of economics.” Journal of Business 59, S285-S300.

13 thoughts on “Ask the Expert – Episode 2 – Using Cost Argument to Push Price Increases

  1. Leo
    You do bring in good points on
    (1) how price increase perceptions may vary across cultures and countries based on their internal frame of reference
    (2) More importantly high and frequent increase in prics due to inflationary conditions can significantly affect customer perception of price increases. What I have written before and what Poundstone writes are are more at micro-economic level and at individual customer level. Unfortunately consumer behavior as a field has not included in it macroeconomics and effect of large shifts. You are absolutely right in stating that there are no studies on it.

    What we need is a new field of “Macro Consumer Bahavior” that also incorporates cultural differences.

    Thanks for contributing. I appreciate you reading and moving the discussion forward.
    -rags

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  2. I agree with Leo ( I’m also from Argentina). The reference price for consumers changes so quickly that is generally accepted a small price increase monthly rather than a big increase yearly. Of course ARG is now under a particular scenario (20%-25% yearly inflation).

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  3. I agree with you under what we may consider normal circumstances.
    My point here is that inflation (2% per month currently in Argentina) distorts everything. Even how consumers consider prices.
    Picture this: money loses its value 2% per month. Once you get your salary, you want to get rid of it asap. What to do, if interest rates do not cover that loss? Spend that money anywhere. On top of this, all prices are changing all the time. So any reference is lost in a couple of weeks.
    Some people think inflation is a pricer’s paradise!!!

    We have tried doing larger price increases less often and generated complaints, because they saw no reason. We tried dividing it into several -weekly- raises, and, since “we all know prices grow all the time”, it is completely normal.

    Anyway, I have not seen in the literature much written about inflation (I have only started “Priceless”)

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  4. Leo
    Thank you for the feedback.
    If a business is going to do price increase it is better to do it one swift move and not as multiple small moves as you recommend.
    Two reasons:
    1. From Prospect Theory we know that customer’s perception of multiple losses (here price increases) is worse than a single loss of same magnitude. That is custtomers will feel more “pain” from 2 $1 increases than they would from a single $2 increase. The opposite is true for gains (hence it is good idea to do promotions in steps, 20% and take additional 10% off).
    2. If the reference price is going to be affected with price increase it is better to do that with one increase instead of letting customers tune to one reference price only to be moved again.

    -rags

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  5. Thanks for the article, very interesting view.
    In our experience in Argentina (where inflation is currently @25% p.a.), I can add two concepts:

    1) Decisions in companies also try to validate the “fairness” in changes of prices. For some of our large customers we disclose our full cost structure to justify increases that would maintain our profit at the same level. The discussion is always whether that level is in $ or in %!

    2) Under an inflationary context (understanding it as a general increase in prices along the market, or, in other words a reduction in the value of money) “fairness” seems to be a bit easier: people know prices go up all the time and do not have the time to validate each increase (the cost of checking it out is higher than the benefit). Therefore, I would recommend constant small increases instead of periodic large ones.

    Hope this helps!

    L

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