Magic is Willful Suspension of Curiosity

We saw magic happen last night on broadcast TV that is supposedly dead. CBS 60 minutes had the scoop of getting Amazon CEO Mr. Jeff Bezos reveal the future of package deliveries. Actually I should refine my statement, we did not see magic happen we saw an expert magician at work, Mr. Bezos that is, not Mr. Charlie Rose. And we all went along with the magician.

Penn Jillette of Penn and Teller pair defines magic as,

“Magic is unwilling suspension of disbelief. For example the audience cannot ask to walk up the stage to look inside boxes. They have to accept the magician’s word for it.”

Clearly Mr. Rose, the reporter whose job is to show disbelief, did not bother to even feign one. He was happy as a child in a magic show. Strike that, have you seen how children these days treat magicians you invite for birthdays? They don’t  sit in their allocated chairs and simply applaud in awe. They nag, they jump from their seats, they want to see what is in the other hand, what is the color of the back of the rabbit. Because children do not suspend their disbelief or curiosity.

But Mr. Rose was happy to be entertained, sit in his comfortable chair and not ask to walk up the stage to look inside boxes.  He could have asked many questions

  1. Why are you telling me this when you just refused to deny or confirm your set-top box roadmap?
  2. Why are you not using this already inside your million square feet warehouses so you do not need people walking miles to pick up products from shelves?
  3. Why is it relevant to a customer how you deliver the package as long as they get it on time?

But reporters these days are afraid of getting access cut. Happy they have the audience. Anxious to become what Mr. Walt Mossberg was to Mr. Steve Jobs to the next Jobs. So they suspend their disbelief and curiosity and let the magicians perform.

Waging Price Matching War

In game theory they talk about deciding your move based on what rational opponents would react. A variant of that strategy is to convince your opponent that you are no where near rational so they better not expect you to do the rational reaction to your action.

For example if you are playing a game of chicken in cars, if you were to break the steering wheel and toss it out the window in front of your opponent then he knows you are not going to swerve. (source: Art and Science of Negotiation). That is strategic irrationality.

In the game of chicken played in retail prices, Amazon is such a strategically irrational player. A recent BusinessWeek article screams

Amazon’s Jeff Bezos Doesn’t Care About Profit Margins

Mr.Bezos has signaled to all other players that he has thrown away his steering-wheel and placed a brick on his gas pedal. They are not going to let up on lowering prices and they can keep at it as long as they can because they have the full trust of their shareholders.

The right move in this game is not to do exactly the same and agreeing to match prices. But other retailers don’t seem to get it.

Target is the latest retailer who decided to play the price matching game not realizing their opponent’s stated irrationality. Target announced they will match all Amazon prices if customers can show proof.At least, unlike BestBuy’s mistake of making it easy for customers to get the price match, Target has added manual steps for customers. But that isn’t enough to stop the bleeding – either customers will do that additional work or simply go to Amazon.

If one player in a market says they will match any lowest price in the market the rational move for others is not to lower their prices because they get no advantage from it and only erode their margins. But Target is not dealing with rational player.

Fundamentally, by agreeing to match Amazon prices, they are saying their store provides no unique products, no unique value and  is undifferentiated from an online store. The right strategic move would be to ask,

“what unique value the store provides to its target customers and what is the right product mix that makes the customers buy from them”.

Even if this would result in severe revenue reduction – because they end up eliminating many products from their shelves – in the long run it would help make Target a profitable venture.

Instead they chose to play the game of chicken with with an opponent who has given up on steering.

This isn’t going to end well for Target. Circuit City here we come.

What effective pricing can do for your business

Take a look at this image courtesy of Planet Money

Revenue difference between MegaBloks and Lego

What you see are the annual revenue numbers for MegaBloks and Lego. Since Lego does not have (any more) exclusive rights to make the bricks, anyone can make them. And MegaBloks does. Its bricks are perfect replacement (as for as I know) for Lego bricks only cheaper.

How cheaper? 50% cheaper. Yet Lego makes 9 times more than what MegaBloks does in a year. Not only in revenue numbers Lego also beats MegaBloks on its margins as well

Gross Margin       70.5% Lego to  40% Mega (source below)

Operating Margin  30.1% Lego to 17.6% Mega.

A little bit of math will convince you Lego has no cost advantage. At 30% cost, even if it halved its price to match Mega’s prices, its margin will be 40%. In other words any (percentage) margin advantage Lego has comes purely from its pricing and not because of cost advantage.

What is going on here? In the words of Jeff Bezos, isn’t MegaBloks working hard to charge customers less and Lego working hard to charge more? Why aren’t customers overwhelmingly picking MegaBloks based purely on price?

If lower prices are designed to drive market share how come Mega has just 10% of market share despite being priced at 50% of Lego?

The Planet Money story says it is because of Lego’s attention to detail and because of their licensing deals for Starwars. But they miss the point. The answer, as in all pricing questions, begins with customers.

Think about the loyal customers who already have spent hundreds if not thousands building their Lego bricks collection and bought into the Lego brand and its messaging. Include the newbies who are getting inducted. Toss in those who are buying Lego as gift for someone else. Do you think any of these customers would make buying decisions based on price? What job do you think these customers are buying Lego for? I bet it is just not as a building blocks toy.

If such customers perceive value at its current prices and are willing to pay such prices there is no reason whatsoever for Lego to give its product away at lower prices. Pricing low because of cost, competition or in the hope of gaining market share is simply not effective pricing.

Lego’s effective pricing driven by customer segments helps it achieve 70% gross margin and 90% of the market.

Finally I should not dismiss MegaBloks or call its pricing bad. MegaBloks likely knows its target customers as well -a tiny fraction that is price sensitive but isn’t likely to grow. They likely found the optimal segment size and the price these customers are willing to pay that will help Mega deliver 17.6% operating margin (nothing to be sneezed at).

But if it really wants to put big numbers on the board it needs to get its own customers who are will hire it for its compelling value proposition and not because it is a cheaper substitute.

There are two kinds of companies – Price Setters and Price Takers

When Amazon introduced its Kindle Fire it positioned it as a direct competition to Apple’s expensive iPad. In a letter published in its landing page, Mr. Bezos drew a clear distinction between Apple’s pricing strategy and Amazon’s pricing strategy. Apple was not explicitly named in the letter, but not hard for all to see who Mr. Bezos was talking about.

The two kinds of companies, according to Mr. Bezos, are those that focus on charging more vs. those that focus on charging less. While that is a pricing distinction Mr. Bezos want to drive for Kindle Fire positioning, there is another way to classify companies – based on the level of control they have in pricing their products. In fact I should say, the level of control they are willing to exercise and follow through in pricing their products.

There are indeed two types of companies; those that work hard to set prices (Price Setters) and those that just tag along, take market prices and work hard to stay alive (Price Takers). Be it charging for perceived value to customers (Apple’s pricing) or charging to reach the mass market and keep out the competition (Amazon), they both have a well defined strategy and work hard to implement it.

When Mr. Jobs was Apple’s CEO he used to say (some version of it)

If we knew how to make cheaper products that we are not ashamed of putting it in your hands, we would have made it

When Mr. Bezos talks about pricing (as recently as last week in Times) he seems to be saying (paraphrased)

We are not thinking short term, we can keep our prices low for a long long time, longer than our competitors can stay solvent

The core strategy and their commitment to follow through on it come through clearly in such statements. Apple and Amazon are Price Setters. They are not going to let the market set their prices.

Apple and Amazon are not alone in this class, Wal Mart , Whole Foods, lulu lemon, Wall Street Journal, REI, and most luxury brands (across all categories) are also  Price Setters. But this is small class of companies.

Price Takers are a large class of companies. They have no pricing strategy or if they have one they lack the will and wherewithal to follow through. They react. They let the markets decide their prices. You can go back and look at recent price drops of many products and see for yourselves who belong to this class.

Price Setters-3

Mr. Bezos wrote in his letter, companies that charge more and those that charge less can both thrive. Unfortunately that is not the case when it comes to Price Setters and Price Takers.

Price Setters will thrive and go on to create significant value over long term.

Price Takers will be relegated to the footnotes of history.