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Consumer-Based Pricing

Consumer-based pricing is the third common approach firms use to set their prices. In this case, the firm first sizes up its customers to determine how much each customer is willing to pay for its product or service and then charges the price each customer is willing to bear. Car dealers often take this approach.5 A dealer typically displays a high sticker price for a car, which is nothing more than a wished-for price intended to frame the value of the car for the customer. Then a salesperson takes the prospective buyer out for a test drive. In the process, the salesperson gathers information about the customer's job, hobbies, family, and so on to help size up how serious the shopper is about the car and how price-sensitive he might be. When the salesperson senses that price is not a primary concern or that the customer is not a deft haggler, he will typically give all kinds of reasons for not being able to bring down the list price much. However, if the salesperson senses that the price is the obstacle to closing the deal, the salesperson will offer a better discount—but only after securing the "reluctant" approval of a mysterious boss behind a closed door and shaded windows.

Customer-based pricing gives the company the flexibility to charge different prices to different customers, rising or falling to match the size of the customer's wallet. Theoretically, the firm can achieve a high volume of sales at the best possible margins. However, an obvious problem with this pricing approach is that it inevitably alienates those customers who end up paying more than the successful hagglers. In the case of car purchases, many economic studies have shown that minority men and women have to pay up to $1,060 more than white males for the same car.6 The backlash against this discriminatory practice contributed to the enormous success of GM's no-hassle, no-haggle sales policy on its Saturn line in the 1990s.

In business-to-business markets, discriminatory pricing can also easily alienate a firm's best customers, with detrimental long-term consequences. The worst is that over time, discriminatory pricing can train the customers to become aggressive bargainers. In the industrial markets, a professional buyer fears a high relative price more than a high price. A high price is a problem for the industry. A high relative price is a problem for the buyer personally. No one wants to think of himself as a sucker, but for a professional buyer, the damage wrought by overpaying isn't only to his pride; it can also hurt his career. He may suffer professionally if he is exposed as less skillful than his peers. Consequently, if the buyer suspects price discrimination, he will do everything possible to exploit a seller's pricing flexibility to secure the lowest price.

Ultimately, this kind of strategy can train good customers to behave badly. If a buyer knows the price she will pay depends on her perceived willingness to pay, she certainly does not have any incentive to dwell on how good and how valuable the seller's products and services are. Nor can she afford to appear interested in the seller's value propositions. The potential buyer might also try to withhold useful information from the seller, just to conceal her hand. She might even take pains to act as if the seller's products and services are no better, if not worse, than anyone else's—a hint that the buyer is perfectly willing to walk away if the seller's price is not competitive. Frequently, the concealment comes at the cost of depriving the seller of the kind of information that would help the seller serve the buyer better, both now and in the future.

This behavior also encourages more comparison shopping. To ensure a rock-bottom deal, the buyer will look to gain an upper hand in sales negotiations by entertaining competitive offers, even if the buyer does not intend to switch suppliers. Collecting competitive bids gives the buyer a decisive advantage. A seller risks legal perils if he talks to other suppliers about pricing, but a buyer is free to solicit competing price quotes. The buyer can then use the quotes as a lever to gain concessions from the seller. Knowing that the seller's salespeople have some pricing discretion, the buyer will try every means, both carrots and sticks, to make sure that the seller doesn't hold anything back.

For example, it is not uncommon for the buyer to embellish price quotes a little to gain a larger price concession. Sometimes those quotes don't even need to be explicit. A former Merrill Lynch chief information officer is famed for having a million-dollar coffee mug: "When an IBM salesman came calling, the CIO would put a coffee mug from a competitor on his desk. The salesman would immediately cut $1 million off the price of each mainframe, for fear of having Merrill take its huge business elsewhere."7

This kind of aggressive negotiation leads both buyer and seller to focus on transactions instead of building a relationship and to channel creative energy into devising ways to win more or less money instead of forging a long-term, win-win partnership. Facing such a buyer, the seller's choice is limited, especially in a buyer's market. You can refuse to budge on the buyer's price demand and try to sell based on a value proposition. In that case, you risk losing a big customer. Or you can compromise, bring the price down promptly, and close the deal. For most commissioned salespeople, such as the IBM salesman facing Merrill's mug of doom, a lower margin is always more appealing than no deal.

The game leaves both sides less happy than they might be. The buyer won't be happy, even if she receives the full discount for which she asked, simply because she can never be certain about whether she could have won an even lower price—so the next time, she will ask for a little more. For the seller, every order costs a little more price integrity. Sometimes this reluctant price discounting can even evolve into an arms race between competitors. Buyers become more demanding, and salespeople ask for more pricing discretion. The salespeople have a good chance of getting such price cuts because they supposedly know customers and competitive situations in the marketplace firsthand. And when they have the price cuts, they will use them more freely, forcing the producer to cut costs.

In this kind of pricing environment, the seller has little incentive to invest in the customer relationship or additional services, and cost cutting becomes the paramount imperative. What typically follows can be best described as a kind of service version of Gresham's law: Bad service companies drive out good. If no buyer seems to care about or wants to pay for customer services, then no seller wants to spend money to provide them. As customer service deteriorates in an industry, product differentiation declines, a new round of downward pricing pressure gains momentum, and the product moves another step closer toward being a commodity. Put it all together, and the industry enters a downward spiral, with the buyers paying less and getting less, and the sellers getting less and giving less. It's a good topic to reflect on during your next long-distance flight—over your lunch of peanuts and soda pop.

From this brief tour of how firms set their prices, we can come to two conclusions. First, the market does not set prices. Marketers do. All the prices we observe in the marketplace do not just spring out of an autonomous, impersonal market. The managers' hands in setting those prices are entirely "visible," regardless of whether such interventions are acts of expediency or strategy. Second, cost-plus pricing, competition-based pricing, consumer-based pricing, and even "lottery" pricing are not necessarily the best ways to price a product or service. In many cases, they are nothing but shortcuts managers use to cope with the weight of their decision-making responsibility.

Unfortunately, ignorance of the power of pricing can have huge consequences. Your company's survival may even depend on your pricing strategies. If you are a retailer, you must pay attention to Wal-Mart's price-dominance strategy. Either find a way to cope with it or be steamrolled, as many have been. If you are a manufacturer in the United States, whether you are in textiles, steel, or consumer electronics, you must heed "the China price"—the price quotes from China that are typically 30–50% lower than state-side manufacturing.8 If you are a financial service company, you must navigate the new reality of deregulations and discount brokerage, both online and offline. Even if you are a high-tech company, you might find yourself in a situation where you no longer enjoy a comfortable lead in technology and you must compete directly or indirectly with companies from South Korea, Taiwan, India, and China—almost always on price and always against a player with a lower cost structure.

Competitors are not the only risk for sellers. Buyers are not as docile as they once were, either. In the consumer market, the Internet has changed the way in which price information is disseminated in the marketplace. A consumer shopping for a car is no longer in the dark about prices. She can easily find information online about the prices different dealers charge for the same car. If she is diligent, she can even find a dealer's invoice price for a car and the amount of the manufacturer's ongoing coupon or rebate promotions on the car. Armed with the price information, the customer might travel hundreds of miles for a lower price and save hundreds or even thousands of dollars on a car purchase. In the industrial market, the Internet plays a similar role in increasing price transparency and expanding the geographical range in which a firm can source its suppliers. As a buyer, when you have extensive price information and a larger set of choices, you become more sophisticated in using that information and choosier in your buying decisions. When you have those savvy buyers in a market, the overall price becomes even more critical for the company.

Price is also becoming more important because product differentiation is harder to achieve in many industries. For example, most desktop or laptop computers have "Intel Inside" and run Microsoft Windows. In the service industries, which now account for more than two-thirds of U.S. gross domestic product (GDP), companies cannot patent their service designs in the same way manufacturers patent their product designs. The resulting lack of product differentiation, either real or perceived, and the new ease of comparison shopping inevitably make price a bigger factor in customer buying decisions.

But at the same time technology is changing cost structures and pricing pressures, it is also giving many companies a whole new set of pricing opportunities. Many industries now have a high fixed cost, typically in development, and a low variable cost in production. In the software industry, for example, a huge cost must be incurred up front to develop the first copy of a program, but the cost of replicating the software is nearly zero. The same is true for many other digital technology–based industries such as music, movies, and information, and, to a lesser extent, for service industries such as airlines and hotels.

In these kinds of industries, pricing can play a considerable role because of a low variable cost and a wide dispersion in the consumer's willingness to pay. Companies with this kind of cost structure can set prices in ways that either harm profitability or enhance it. An undisciplined manager might seek a quick "high" in volume through an unsustainably low price. On the other hand, a more sophisticated manager might take advantage of the situation by designing a creative pricing structure to attract a certain kind of profitable customer. In either case, the price is now becoming an increasingly important differentiator.

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