We are pricing $400 for $450 because customers asked us

sbux_rose_goldWhen writing about Starbucks pricing the simplest option for me is to copy and past my past articles. After all that is exactly what Starbucks does when introducing pricing changes or super-premium products. See for example here  and here. Perfectly executed price increase and almost as effectively communicated, resulting in better profits. Make no mistake, I admire and support it and there is nothing wrong with it.

This time it is the repeat of the $400 Steel gift card. Here is what I wrote last year,

That is correct. It costs you $450 to get $400 because Starbucks said it costs them a lot to make this steel card. While I called this egregious pricing, at least 5000 people did not think so. The card was sold out and worse was sold for much higher prices on eBay.

They then said, they were charging $50 more because they spent more than $50 just to make the card. And what do they say now,

“It actually costs us more than $50 to produce this card,” she said. “That’s what you’re paying for — the quality of the card itself.”

See they are actually losing money, just for you so you can exchange $450 cash that has maximum fungibility with $400 of payment that has no fungibility. They are doing you a favor so you won’t feel guilty every time you fork over $4, after all Prospect Theory says pain from single spend of $400 is almost same as pain single spend of $4 (or something like that).

Another interesting thing to observe this year are the prices in eBay. Last year a curious thing happened,

Pricing on $0 gift card provides great insight on buyer perception. It appears keeping the full $400 value of the card helped increase its value among buyers. That is, when sellers left $400 on the card buyers bid additional $600 for that $400.

We can try to explain away why anyone would pay $650 for an empty card. But nothing in rational economics can explain why someone will bid $1.5 for each additional $1.

Current highest bid is $2499 (with the $400 value retained). And don’t worry, shipping is free.

For all the jokes we make about left tail, they seem to have enough dispensable income than rest of the distribution. I wonder who really is the left tail here.

The Incredible Starbucks Steel Gift Card

To refresh your memory, just before the holidays Starbucks launched a limited edition (5000 only) steel gift card priced at $450. The card carries a value of $400 and comes with some sundry benefits like free refill on brewed coffee and free drink on birthday.

That is correct. It costs you $450 to get $400 because Starbucks said it costs them a lot to make this steel card. While I called this egregious pricing, at least 5000 people did not think so. The card was sold out and worse was sold for much higher prices on eBay.

By last check there were 510 sold listings.

  • 70 odd listings were for just the empty card ($0 value) sold from $325 to $650
  • Most of the listings were with the full $400 value and sold from  $670 to $1250
  • Very few listings with $5 and $25 value and with no other values

What can I say about this?

Pricing on $0 gift card provides great insight on buyer perception. It appears keeping the full $400 value of the card helped increase its value among buyers. That is, when sellers left $400 on the card buyers bid additional $600 for that $400.

We can try to explain away why anyone would pay $650 for an empty card. But nothing in rational economics can explain why someone will bid $1.5 for each additional $1.

But I think the only reasonable point we can make from this data is – the left tail of human civilization has at least 5000 people, the left most has at least 510 people (those who won the auctions) and rightmost has 510 people, those who made a profit.  (Note: Subtract the 510, those who sold, from 5000 and add back those bought and you get 5000 in left tail.)

And you my friend, I know, is in the right tail, simply because you are reading this.

How entrepreneurs estimate the probability of picking a red ball from a urn?

Stay with me on this till the end of this article.

Suppose you asked me the probability of picking a red ball from a urn that has 10 red balls and 10 green balls, I would say the answer is 1/2. I cannot say with certainty what the next pick will be but if you picked a ball enough times I can say 50% of those instances will be red balls (yes you return the ball after each pick).

But what if you brought a mystery urn (of unknown size) and didn’t reveal how many red and green balls are in the urn? Heck, what if there were lot more colors than just red and green? I would have no idea. My best approach would be to guess a number (using my gut feel or intuition) and say something like  1/1000.

But as someone too analytically bent I would find it hard to play this game. You didn’t tell me how many total balls, the different colors and whether the urn had a red ball or not. I cannot even apply Bayesian reasoning to refine my answer.

Entrepreneurial outcomes,  says Saras Sarasvathy, is like estimating chances of picking red balls from such a mystery urn. According to Sarasvathy entrepreneurial thinking is

Whatever the initial distribution of balls in the urn, I will continue to acquire red balls and put them in the urn. I will look for other people who own red balls and induce them to become partners and add to the red balls in the urn. As time goes by, there will be so many red balls in the urn that almost every draw will obtain one. On the other hand, if I and my acquaintances have only green balls, we will put them in the urn, and when there are enough, will create a new game where green balls win

It is hard not to imagine someone you know doing exactly this – hustling to find those with red balls to add to their urn (discover a few early adopters and build on them) or pivoting to redefine the game as picking green balls not red balls.

That is the clear distinction between the mind of an entrepreneur with irrational optimism and that of rational person. And I do not use rational and irrational to say one is better than other rather  use irrationality as equally positive trait as rationality (or rationality as equally negative trait as irrationality), like the way Dan Ariely did.

Rational people, there are many of us, refuse to play the guessing game of picking red balls from unknown mystery urns. But if picking red balls is important to significantly improve our lives, someone has to do it. However no single person can keep on trying with a single urn. And most run out of cash and time before they can add enough red balls to their urn.

That is why we need many many entrepreneurs with irrational optimism to keep picking balls from their own mystery urns. Most end up picking all kinds of different balls but a few will find urns and change it in such a way to always draw red balls.

Where do you fall?

 

Unlike an Economist

An economist is trained to assign value (in measurable units too) to every action we undertake and everything we buy. There are always trade-offs and costs including opportunity cost of not picking the next best option. If an option does not offer positive expected net present value it is not worth undertaking. If there are multiple options, then you pick the one that offers the maximum expected net present value.

We do not run our lives like an economist. Our decision making is flawed and is based on emotions than rational thinking. When looking at the decisions made by others, with the advantage of hindsight and emotional detachment, we make commentaries about the qualities of those decisions. The New York Times has an article by DAVID STREITFELD on the unfortunate homeowners who used storage to stash their belongings after foreclosure on their homes. David says,

“… some people cannot keep up with their storage bills any better than they could handle their mortgage payments and the storage companies are auctioning of their property for a pittance”

An economist would ask, have these people considered all options before choosing storage as the best option? David asks,

This is the eternal mystery of self-storage. If the material was worth
money, it was foolish to let it go to default. If it was not worth
much, why spend at least $50 a month to store it?

The problem is most people, and we can safely say all of these people who used storage only to lose the contents, do not have a formal decision process. One could argue that if they did, they would not have reached this stage in the first place. But if we give people the benefit of doubt, unexpected events and bad luck could easily be the reasons that drove them to foreclosure. Kirchler and Rodler of University of Vienna say in one of their cases on Consumer behavior,

“People in private households make decisions when they are still groggy in the morning or tired again in the evening after a day’s work. Economics decision making is imbedded (sic) in the daily routine of a relationship, which is faced with a multitude of different decision topics which often do not present themselves one after the other but rather demand simultaneous solutions”.

At the time of foreclosure they are already stressed and are trying to make a living and/or support their families. Their already sub-optimal decision making process is further weakened by their current state. They cannot make economic decisions on whether to sell the stuff right away or pay the rental charges to the self storage.

People tend to look at their property as a representation of their past, a life they once had and want to have back in the future. While it might make economic sense to sell these off rather than spend $600 a year to store them, only to lose them later, their emotional attachment makes them choose the option of storing instead of selling.

Unlike an economist people are not rational. Unlike a economist people are emotional. Unfortunately, this emotional decision process destroys private and public wealth.

This brings us to the questions,

  1. Should people be making their own decisions?
  2. Should there be professional decision makers, trained economists, who can take on the multitude of decision problems that require simultaneous solutions?
  3. Just like people are not qualified to treat their own medical conditions, should they leave their economic decision making to professionals?

Addendum: People may very well be making a valid decision if they think they value their possessions to be more than the cost to replace them. This could easily be the case as explained by Endowment effect that states we value things that we own more than what the market is willing to pay to buy from us.