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Value-based pricing: Fair or foul?

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25th Feb 2014
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As Accenture describes in a recent book on ‘Contextual Pricing: The Death of List Price and the New Reality’, the rise of Big Data provides companies with unprecedented opportunities to personalise their products, services and experiences for customers. Armed with detailed knowledge about individual customers, the products they have, their recent behaviour and what they are doing right now, companies can use contextual marketing to pitch exactly the right product at exactly the right price to the customer in their current circumstances.

Increasingly, the price will depend on how much the company thinks the customer is willing to pay for the product in their current circumstances. A fire extinguisher is more valuable to a customer whose house is burning down than to one whose house isn’t. So - metaphorically speaking - why not charge more for it when the house is already alight. The customer may be offered the same fire extinguisher at different prices in different circumstances.

This type of ‘value-based pricing’ brings two groups in direct conflict with each other. In the blue corner are the economists with their emphasis on market-driven pricing, whilst in the red corner are the moral philosophers with their emphasis on justice theory.

The economist’s view: context trumps fairness

Ask an economist about value-based pricing and he will likely tell you that pricing is the way that markets set the value of a product. The more valuable a product is, the higher its price will be (assuming a fixed supply of the product). Just like the customer whose house is burning down. In pricing, context is everything.

There is no economic reason why a person with a greater contextual need for a product should not be charged more than someone with a lesser need. This is the simple economic principle behind the widespread use of yield management by airlines, cruise lines, hotels and companies with seasonal, perishable or variable value assets.

The philosopher’s view: fairness trumps economics

Ask a moral philosopher about value-based pricing and he will give you a very different answer. Value-based pricing is fundamentally unfair and easily leads to moral outrage. Amazon was roundly pilloried in the business press for its early experiments with variable DVD pricing based on customers’ previous purchasing history.

Taken to an extreme, value-based pricing can result in prosecution through price-gouging laws. The State of New Jersey has prosecuted hundreds of hotels, petrol stations and building suppliers for price gouging in the wake of Hurricane Sandy. However, some economists believe that price gouging is not only fair, but reduces essential shortages in emergency situations. The issue of price gouging has sparked a fierce debate in the aftermath of Hurricane Sandy. 

When does value-based pricing work?

The rapid increase in the availability and use of big-data suggests that value-based pricing will also increase in usage. The conditions under which it works best are well understood. Werner Reinartz sets out five conditions in a paper on ‘Setting Prices in an Online World: When Price Customisation Works (And When it Doesn’t)’. And it does work; airlines are estimated to increase their revenues by 4-6% and hotels by 3-5% through yield management, without increasing their operating costs. 

But it also has an impact on customers’ perceptions of  fairness. Kees Correia Nunes da Silva shows in a paper on ‘The Impact of Yield Management in the Airline Industry on Customers’ Feelings of Price Fairness’ that customers feel unfairly treated when airlines extract higher prices through yield management rather than through developing closer relationships with them. The curious thing is that a number of studies show that the relationships built through frequent flyer programmes increase revenues by significantly more than those available through yield management; by 6-14% of the average fare paid.

Should customers in the most need be charged higher prices? That's may be good for sellers but it’s not so good for customers. Or should all customers be charged the same price? That's good for customers but it’s not so good for vendors. As the witches in Macbeth cry, "fair is foul an foul is fair!" 

What do you think? Is value-based pricing a fair economic model? Or is it a foul affront to our moral sensibilities?

Graham Hill is a partner at Optima Partners.

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By rockygramm
25th Feb 2014 14:47

customers are not happy when new customers get special deals that they are not offered so i would envisage them being up in arms if companys started these kind of games!

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Dr. Graham Hill
By Dr. Graham Hill
26th Feb 2014 17:01

Hi Rickygramm

Thanks for your comment.

Despite the analytical, economic and moral challenges of value-based pricing, it already IS in widespread use. At least, companies are starting to experiment with it. In addition to Amazon, and airlines, hotels and other users of yield management tools, other companies that have used it successfully include Schneider Electric, Intel and Volvo.

As Ng et al’s point out in an AIM briefing on ‘Outcome-based Contracting’, offering customers ‘servitised’ outcomes, rather than products or services, is an increasingly popular way to implement value-based pricing. But it is not without its challenges. The biggest one faced by companies wanting to implement it is their lack of understanding of customers and what they really value.

Graham Hill

@grahamhill

Note: The value-based pricing discussed in this article is NOT to be confused with the value-based pricing of pharmaceuticals being discussed by the UK Govt as a way to ensure that the price of new prescription-only medicines is based on their demonstrated clinical efficacy, rather than on the margins desired by their manufacturers.

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Wim Rampen
By Wim Rampen
26th Feb 2014 21:02

Hi Graham,

Excellent topic! Here's my take on it.

There's nothing wrong for a company to try and capture value in return for a service. And of course that value should have a clear link with what the Customer is willing to pay, not your costs per se.

The example you mention is not really an issue of willingness to pay, but of sensitivity to a price increase. With the increase of contextual data/information it is not a surprise that the traditional value extraction consultants are seeking to use that information/insight to extract more.. But they are forgetting that Customers may be willing to pay more at the moment of exchange, but that doesn't mean they will also perceive more value created when the experience is being consumed..

The only conclusion possible can be that for a price to be higher in a specific context the value perceived during consumption should also be higher. If not, Customers feel robbed afterwards.. 

In other words: trying to use contextual information to increase price? try using contextual information to improve the Customer's experience too, and you may get home safe. Otherwise, be careful, b'cause this new practice me just bite you in the ....

Even shorter: Extract more value, or co-create more value? Your pick.

Wim

p.s. great to see you blogging again! 

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Dr. Graham Hill
By Dr. Graham Hill
27th Feb 2014 10:22

Hi Wim

Thanks for your comment.

As is often the case, I am completely at one with you on your suggestion.

As companies start to add new contextual data (What is my current context, location, & activity?), social data (Who do I associate with? Who influences me?) and needs data (What are my aspirations & goals? What jobs & outcomes are important?) to their existing customer, contacts & transactional data, they will be in a much more powerful position than they are today.

Big data is here to stay. It is how we use it that is critical. Many companies will myopically use it for their own short-term gain through improved marketing, sales & service. They risk a privacy backlash from customers, data intermediaries and Governments who increasingly, see the data as belonging to customers not to companies.  The real winners will be those companies who see big data as a game changer to reinvent how they go to market, not just for themselves, but for their newly empowered customers too.

Big data needs to benefit customers, not just companies

Graham Hill

@grahamhill

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Mike Boysen
By Mike Boysen
27th Feb 2014 13:47

Hi Graham,

"A fire extinguisher is more valuable to a customer whose house is burning down than to one whose house isn’t"

Wow, is this how the masses will interpret Value-based pricing? I can't wait for value-based pricing in the Emergency Room! I always thought it was based on the value of the outcome a service would facilitate for a particular customer. It de-emphasizes our tendency to attribute value to activities (and units of time) and focuses on the value delivered by means of an outcome. 

If a similar engagement with one company results in a $10 MM annual benefit (whatever that is) and only $1 MM annually for another company (maybe due to scale) and if we look at a return on the investment, we would be asking the latter company to accept a much smaller return if both were offered the same price for the service. It's up to us to determine if we can offer that service to the latter. If the effort for both is similar on our part, is it unfair to ask more from the former? I don't think so because we are co-creating that outcome and should get an equitable share of the value that is realized (or estimated to be realized). Whether there are guarantees is a whole other matter :)

I don't see how Big Data will be successful here any more than it can identify jobs & outcomes at the push of a button. Is Big Data forward looking? How can it determine an outcome, or measure it? I think the pioneers in this area (like Alan Weiss) are worth having a look at since the term is not new. This takes it in a fundamentally different direction as it seems we are talking about consumer pricing and not the consulting world where it has been talked about (and practiced) for a long time.

Once again, it seems we have seen a term/concept hi-jacked by the Easy Button crowd. I've already seen the consulting version of this as hours*rate=fixed price (voila, value pricing!). I don't think Value-based pricing falls into either the market-driven or the justice theory camps; at least not the way I define it. 

All the best,

Mike

P.S. I'm with Wim, it's great seeing you post again. I miss having a place to have long form conversations - where I tend to get educated by you ;)

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Dr. Graham Hill
By Dr. Graham Hill
27th Feb 2014 14:47

In today's Fast Company newsletter is an article describing how AirBnB has developed predictive pricing algorithms, using big location data, to help the army of virtual hoteliers price their rooms better.

Fast Company

How AirBnB Solved the Mystery of Predictive Pricing

http://bit.ly/1bOzEdf

According to the article, virtual hoteliers who used AirBnB's algorithmic price got 3x the numbers of bookings than those that didn't. It just goes to show how when you get the price of services right - so that they delivers the optimum value for both customers and suppliers - how both parties benefit from value-based pricing.

Graham Hill

@grahamhill

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Dr. Graham Hill
By Dr. Graham Hill
28th Feb 2014 10:46

Hi Mike

Thanks for your comment.

Value-based pricing is all about pricing your products based upon what you think customers are willing to pay for them, rather than on what they cost to produce. Value-based pricing is a continuum. At the simpler-end is differentiated pricing where different people are charged different prices. The pricing of identical smartphones at different price-points depending upon whether you buy them in the USA, Europe or Asia is a good example.

At the more complex end is true value-based pricing such as that Amazon was pilloried for experimenting with. Perhaps the most extreme use of value-based pricing is speeding fines in Switzerland, where the size of the fine is proportional to your income. A Swedish man caught driving his Mercedes SLS AMG at 186mph was reputedly fined over USD1 million dollars (http://bit.ly/1loNZ3h). This is state-sponsored price–gouging of the worst kind.

Value-based pricing is only really the implementation of the principles of supply and demand at the individual level. If your house is burning down, you are more likely to pay more for a fire extinguisher, providing it is not too late for the extinguisher to do its job effectively. If you need the last ticket to the Opera, you are more likely to pay more for that too. As Harvard philosopher Michael Sandel discusses in his book, ‘What Money Can’t Buy: The Moral Limits to Markets’ (http://bit.ly/1horng5), markets are amoral in that they don’t consider ethics. This can easily lead to patently unfair pricing that price-gouging laws are there to prevent (except, apparently in Switzerland). Perhaps this is why Financial Time economist John Kay advises his readers, that “if you want a good time at a bar, go with an anthropologist rather than an economist” (http://bit.ly/MAKvvl).

The emergency room and consulting examples you use are both cases of cost-based pricing rather than value-based pricing. The emergency room is priced based upon the high costs of providing the complicated facility plus the margin the hospital requires to keep its shareholders happy (at least in the US). It would probably be highly unethical to charge rich patients more when they arrive at the emergency room. It would also clearly violate doctors’ Hippocratic Oath (http://bbc.in/1huMUTR).

Consulting is no different. Assignments are priced based upon the high costs of providing experienced consultants plus the margin the consultancy requires to keep its partners happy. Consultants are not guided by established ethical standards like doctors are, but few consultants I know would actively gouge their customers. They always have their eye on the next assignment. Many consultants have tried to offer outcome-based contracts but the complexity of their clients’ business systems, the dominant role of client resources in value creation and the phenomenological nature of consulting make it very hard to calculate and agree on a value-based price beforehand. 

Big data should have a big impact on value-based pricing. Most pricing today is cost-based at the market rather than the value-based at the individual level. As companies start to gather more data about individuals, particularly more contextual data about them, they will be able to start to price for individuals based upon their current circumstances. If the insurance company knows – because of the data logging telematics attached to your car – that you are a careful driver they can and should give you a lower price than the average customer for whom they don’t have any individual driving style data (http://bit.ly/1mK75Th).  

Graham Hill

@grahamhill

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Mike Boysen
By Mike Boysen
28th Feb 2014 12:55

Graham,

I have always viewed value-based pricing as directly related to outcomes. Charging higher earners more for a speeding ticket hardly has anything to do with outcomes; that's just politically motivated re-distribution. I guess I will have to sit back and see how well companies are able to harness Big Data to identify outcomes of consumers. Does one consumer derive a more meaningful functional outcome from a computer than another? Undoubtedly. How about an emotional outcome? Probably. How will we know this prior to purchase? Big Question Mark concerning Big Data although I haven't read all the PDFs yet :)

There are definitely consultants who do the opposite of what you suggest - and I disagree that it's gouging. How many times have you been called in to fix another consultants "outcomes?" Just as with the majority of companies who can't sustain growth for extended periods, there are only a small percentage of consultants who can successfully align their services with value created , and set the investment level accordingly - and then deliver the expected outcomes. They have to be prepared to guarantee their work. A review of litigation in the press convinces me most are not prepared to do that either.

I predict we will see the same success in the penetration of these ideas as we have with past ideas. So few will ever get it to work and so many will abuse it, or simply misunderstand it. I believe you are the one who has frequently reminded me that everything/one drives toward average/equillibrium in the long run. I can't remember exactly how you phrased that (please remind me) but it seems appropriate here. 

I'm curious, and this may be unrelated, but are you taking the position that Big Data can possibly create forward looking metrics? If so (which I'm not ready to support) what will happen when everyone has access (see previous paragraph)? 

Mike Boysen

@mikeboysen - although I don't tweet that much :)

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Dr. Graham Hill
By Dr. Graham Hill
28th Feb 2014 16:55

Hi Mike

Thanks for your new comment.

I agree with you in principle. If value is based on how well the tools you provide customers help them do their jobs and achieve their desired outcomes, then yes, value-based pricing should be based on outcomes. But therein lies a problem. If you remember your jobs-to-be-done reading you will recall that a customer job can create a number of desired outcomes. These outcomes are highly context dependant and their relative importance may change over time. To continue with the fire extinguisher metaphor, the outcomes it enables will have different relative importance depending upon whether your house is on fire, where functional fire extinguishing outcomes come to the fore, compared to when it is not on fire, where emotional peace of mind outcomes dominate. It isn’t much of a stretch of the imagination to see how payment for the outcomes associated with putting out your burning house would be much larger than payment for the outcomes giving you peace of mind. Ergo, the fire extinguisher would have a higher value-based price just after the house has caught fire and the fire can still successfully be extinguished, compared to before a fire has started and also, to after the house has burned down to the ground.

The granularity of big data means that you can gather much more data about the customer’s current context and thus, armed with your knowledge of their desired outcomes you could offer them an individual value-based price.

I agree with you that we will have to wait and see if companies use big data to offer customers individual value-based prices driven by their context. My betting is on them just using it to target customers with more granular, but inevitably more of the same junk marketing. Don’t blame the marketers though, blame the short-term focus of the organisations within which they have to work (http://bit.ly/1objkDK).

Whereas the medical profession has moved on to focus on outcomes, the consulting profession is still focussed on outputs. As an LSE report on ‘Measuring Social Impact’ (http://bit.ly/1bS52HY) shows, there is a world of a difference between them. Outputs are the things you get from doing a consulting assignment, e.g. managers interviewed, reports written and plans developed. Outcomes are the changes the outputs produce in the client, e.g. motivated staff, selected technology suppliers and plans implemented. Let’s not even think about the next step, impacts! If consultants analysed their clients using jobs-to-be-done they would identify the same outcomes. However, consultants rarely get asked to create outcomes for clients. Clients usually prefer to create them themselves. That they often fail to do so is as much dependent on their poor implementation skills as it is on consultants’ unimplementable reports. Without the ability to effect outcomes for clients, it is no wonder that they price assignments based upon their costs plus their desired margin, rather than on the value delivered to clients. Alan Weiss may drive a Bentley, but he has never had to deal with bureaucratic systems implementors! Or their equally bureaucratic clients.

It is Michael Mauboussin who reminded us in a paper on  ‘Death, Taxes and Reversion to the Mean’ (http://bit.ly/MBtKAm) that most companies tend towards the norm (if you look over a sufficiently long period). But that is by no means inevitable. Big data used intelligently may confer smart companies with a temporary competitive advantage (http://bit.ly/1hZhrfW). That is probably as much as any company can hope for.

Graham Hill

@grahamhill

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Mike Boysen
By Mike Boysen
28th Feb 2014 17:46

Thanks Graham. I do remember my reading on the many outcomes which is why I view this as a one-to-one type of effort. I wonder if big data will ever be able to define jobs, map them, identify outcomes and also score them. Now, that would be BIG!

@mikeboysen

 

P.S. Get that other piece published, I'll be waiting :)

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