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.

Endowment Effect – When a bird in hand is more than two in the tree

Here is an Ad for Wendy’s double stack burger that shows very neatly Endowment Effect. (wait for 7 seconds into the video for the Wendy’s Ad, as the beginning of the video has another Ad for Religulous)

The Adman says, “your burger has increased in value”. This is only partly true as the value is in the minds of the customer who is holding it and it is the perceived value. Endowment Effect is a theory introduced by Thaler  (of Nudge) and it states that people who own things  tend to value these more than others. Since their perceived value goes up, they are less reluctant to part with the goods at prices they bought or at the current market price.

This is the same reason home prices are not falling as fast as economic  theories suggest – people own their homes more than the market is willing to pay.

As a corollary, if the customer feels ownership of the object then their   willingness to pay goes up as well. An example of this was discussed in my last post  You touch it! You own it!