Typical Pricing Methods in Use Today
I will call the following methods of pricing “default” because they appear to be in place in some businesses in the absence of a better method:
• Classical Economics and Ye Olde Supply and Demand Curves
• Follow the crowd
• WAG, SWAG and STICK methods
• Estimating solutions
• DIY (Do It Yourself) Estimating
• The Trap of Customer Driven Pricing
• The Un-Trap of Customer Driven Pricing
Classical Economics and Ye Olde Supply and Demand Curves
“In 1890, the English economist Alfred Marshall suggested that if a parrot were trained to answer ‘supply and demand’ to every question it was asked, the parrot could be given a degree in economics.” [1]
If you studied Economics 101 at some point you probably learned about Alfred Marshall’s supply and demand curves. The intersection of the two lines was meant to indicate where price levels would stabilize in a “perfect” marketplace.
Table 3: Supply and Demand
In Table 3, 50 units will sell at $100. Fewer than 50 units will sell at a price higher than $100 and more units will sell at prices lower than $100.
In Table 4, the point of equilibrium (e) is reached by the intersection of supply at 100 units and at a price of $33.
Large quantities in the presence of low demand means low prices. Supply will increase in the presence of high prices and therefore glut the market, forcing prices down. In reverse, a shortage of inventory in the presence of constant demand forces prices up. The whole system finds equilibrium where the two are balanced.
Table 4: Equilibrium
The supply and demand relationship is used to justify the assumption that dropping prices will result in more sales. However, Alfred Marshall and Economics 101 always prefaced discussion of the graphs “in a perfect world.” Of course, this perfect marketplace bears little resemblance to the day-to-day rough and tumble of running an auto-body shop, or roofing a house, or being a consultant. In fact, it bears no resemblance to highly visible and well-documented industries such as those of oil and diamonds. If you consider that a fistful of oil companies and a cartel (OPEC) control the price of gasoline, you will understand that the marketplace is distorted. Diamonds, until recently, were virtually a planet-wide monopoly of the DeBeers company founded in South Africa at the end of the 1800’s. Not only did DeBeers control the mining and distribution, but also the cutting and retailing of the stones. Attempting to compete against DeBeers was like a modern version of Don Quixote charging at windmills on his horse.
Why is the theory so useless to the average small business owner?
Ninety-nine percent of small businesses have no way to test their pricing model daily. If you sold pork bellies on the Chicago Exchange, the price would move each day according to the supply from the pig farmers and the demand from the packing houses. But there is no fluid marketplace for hose reels, clothing, or pasta. That marketplace function is undertaken by the business owner and his or her store. This means that knowing the theory of supply and demand is only good enough for the big picture and that uneven levels of local supply and demand will lead to price differences.
But the supply and demand theory is not dead. The availability of technology is having an impact on informing suppliers and customers, and flattening prices for commodity items. For example, a recent Economist article[2] noted the impact of cell phones on sardine fishermen in South India. Before the advent of cell phones, some 12 percent of the sardine catch was destroyed due to local market gluts. Afterwards, a fisherman with cell phone in hand could find the best price for his catch while at sea and then sail for the port with the highest prices. Prices reached a uniform plateau at 4 percent lower, on average, up and down the coast, and fishermen made 8 percent higher profit.
Table 5: Why Do Prices End In 99¢?
In Canada, knowing that the number of housing starts has fallen will lead you to the inevitable conclusion that demand for lumber, hardware, and fixtures will likely suffer. It will suggest that finding a new market is important or that you need to find a way to out-manouever your competitors.
Knowing that the number of road accidents rises in winter, stabilizes during the shoulder seasons, and rises again in the summer due to vacation travel has an impact on your auto-body and paint shop business, your cash flow, and perhaps on where you set seasonal prices.
Supply and demand also affects businesses for their labor market. In Canada, where the labor market is so fluid, it seems the whole world knows the spread between statutory minimum wage rates and the bottom rung. In a downturn in the economy, the newspaper classified help-wanted ads shrink, and wage rates first flatten and then inevitably go down.
Fluidity also impacts contract bidding. It is a corollary of this type of business that the price is tested on each occasion because someone is asking for bids and your bid has to survive that test each and every time. Bid success is an important “metric” or measurement in business to determine whether prices should move up or down in response to the demand from customers and the supply of competitors.
Where to Begin? Follow the Crowd!
For most small businesses, the opening-day pricing regime starts with checking the competition’s rates and prices, and then following the crowd. This is even the recommended strategy in many popular guides for small business. Merely following the crowd is all right but money is probably left on the table since the business is now just one of many, and the product or service is being priced like an undifferentiated commodity, e.g. pork bellies.
Table 6: Prohibition Story
The upside is that this strategy is simple and easy. You don’t have all the time or money to spend developing a Unique Selling Proposition to get the full value for your services or product and you don’t have to go out of your way to be better than all the rest. (For more about Unique Selling Propositions, see Chapter 4.)
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