Why Pricing Decisions Need More Than Management Intuition

The past year has wreaked havoc on many industries. Companies have faced a range of issues related to customer strategy: sharp drops in demand, excess capacity, heightened price sensitivity, and aggressive pricing decisions by competitors. One important takeaway from the unprecedented impact of this crisis is that executives need to question many of their long-held beliefs about the best way to deal with rapidly changing customer needs.

In this article, we describe six real-world customer strategy and pricing scenarios that many executives have faced in the past year. We discuss the prevalent, intuitive responses that many companies have made in response to each type of challenge and then examine when and why those intuitive responses may not be that sensible after all. Drawing on Daniel Kahneman’s work on dual-process thinking, we contrast the effects of a System 1 (fast and automatic) response with a System 2 (slow and effortful) response and suggest more thoughtful ways to approach the six scenarios.

What binds the six System 2 responses together is the practical application of sound economic and strategic thinking. These insights should help executives make smarter decisions as the world moves on from the current crisis — and faces potential new ones.

Situation 1: “Going through a major recession? Give temporary discounts.” COVID-19 has plunged the global economy into the worst recession since World War II. The significant global decline in GDP implies that people, on average, are getting poorer. An executive’s intuitive, reactive response (System 1) may be to lower prices. Executives may issue these changes in the form of clearly communicated, temporary price discounts rather than cuts in list prices so the prices can return to nondiscounted levels when economic conditions improve.

This recommendation seems sensible on its face. But when we activate System 2 thinking and evaluate the recommendation in more depth, a different conclusion emerges. Economists distinguish between “normal” and “inferior” goods: Inferior goods are those for which demand increases as consumer incomes decline, whereas normal goods are those for which demand decreases as consumer incomes decline. This means that the System 1 recommendation does not hold for inferior goods (for example, budget cars as opposed to premium vehicles). Companies should confine temporary discounts to their normal goods because demand for their inferior goods is going to increase regardless. Conversely, when GDP picks up again, they should not raise prices for the inferior goods. This takeaway is important for companies with numerous products within a given category (for example, a food company that offers both value-for-money and gourmet pastas).

Situation 2: “Uncertainty makes people reluctant to spend? Let’s lower prices.” We all know what uncertainty does to stock markets: Big jumps in uncertainty trigger sharp falls in stock prices. By analogy, an executive’s intuitive, quick response to the pandemic-induced uncertainty may be to lower prices. For example, the uncertainty about future travel policies and restrictions may lead lodging businesses to cut prices on their rooms.

However, a more thoughtful, System 2 approach starts with the realization that uncertainty positively affects demand for many services. In the case of hotel bookings, uncertainty about future travel restrictions makes customers hesitant to make bookings and reduces their willingness to pay for a hotel room. However, their willingness to pay for the option to cancel without penalty will increase, so their total willingness to pay for the bundle (i.e., room plus free cancellation) will be less affected. Consequently, a lodging company can minimize the downward effect on room prices, provided that it automatically includes free cancellation. To customers, it appears that the cancellation service is free, but in fact, it is the base hotel rate that has decreased while the cancellation option commands a higher premium. The takeaway is that the downward price effect from higher uncertainty can be mitigated by offering services that are valued more by customers when these factors are at play.

Situation 3: “Costs have gone up? Pass them on to customers.” COVID-19 has led not only to dramatic changes in the demand for products and services but also to severe cost increases. In food retailing, for example, costs have increased due to various sanitation requirements. The cost impact may also be more indirect; take the case of the agricultural workforce, where shortages are resulting from travel restrictions. A company’s System 1 response may be to pass on these cost increases to customers through higher prices, but once again this overlooks key considerations.

When it comes to the link between cost increases and price increases, economists point to the difference between fixed and marginal costs. An increase in fixed costs (for example, the installation of partition screens) will cut into the company’s total profits. It should not, however, induce the company to raise the prices of its products, provided that the initial prices were set at the optimal levels: Starting from a very high price where no one buys and revenues are zero, the profit-maximizing price is reached when the marginal revenue of lowering price equals the marginal cost of doing so. Fixed costs do not enter the picture because they affect neither marginal revenue nor marginal cost. An increase in marginal cost, in contrast, affects that balance and should, if everything else remains constant, lead to higher prices.

Situation 4: “The business is losing money? Raise prices to recover losses.” As a result of the crisis, numerous businesses are losing money for the first time in years. Leaders might be inclined to raise prices to recoup steep losses. Unfortunately, this approach may lead to a reduction in revenues that is larger than the costs savings from the reduced volumes, and thus a decline in profits.

A more thoughtful response would be to recognize that losses can be induced by various factors. It is therefore critical to analyze which external and internal factors are at the root of the loss and act accordingly based on the company’s scenario:

• If the loss is due to a marginal-cost increase, raise prices.
• If it is due to a drop in demand and the company has excess capacity, decrease prices temporarily.
• If it is due to a fixed-cost increase, do nothing.

Situation 5: “Customers are spoiled by free services? Go for value pricing.” In order to keep customers who are struggling during the crisis loyal, many B2B companies are offering services such as free shipping or rush orders at no extra charge. The question of what to do with those freebies will pop up as soon as the economy picks up. Intuition might move executives to avoid changing tack as long as their competitors continue to offer the free services.

Unfortunately, doing nothing is costly in its own right. A System 1 response may be to go for value pricing, particularly since those free services were clearly communicated as being temporary: Assess the value that the customer attaches to a service, and price it in a way that the value is shared “fairly” between a company and its customer. Unfortunately, value pricing does not work for services that are not unique and that competitors continue to offer for free. In that case, value pricing does more harm than good, as the company will end up losing plenty of customers.

System 2 thinking suggests a better, negotiated approach, at least for B2B markets with repeat customers: Propose to customers before the year starts that they will obtain an end-of-year discount for the proportional reduction in the number of rush orders relative to the number in the past year. This leads to a pure win-win outcome. Customers will benefit from ordering regularly whenever they can and will place rush orders only when really needed. And since the company rewards customers only for improving their order behavior, not for placing the orders they make regularly anyway, it will gain more compared with a scheme that gives customers a discount for ordering regularly.

We should note that the scheme works only in markets where end-of-year service negotiations between customers of the same supplier are relatively nontransparent. That is the case in many B2B markets, in contrast to B2C markets, where price policies tend to be public.

Situation 6: “Some businesses have been lucky enough to benefit from COVID-19? We haven’t, so we’ll just have to sweat it out.” There are plenty of companies that have benefited from offering or creating new products and services that meet the customer needs that have been particularly acute during the pandemic — such as home entertainment, food delivery services, and cleaning products, to name just a few categories. Other companies have been able to mitigate the impact in one line of business with gains elsewhere. An executive’s intuitive System 1 response may be to shrug off these incidental success stories as exceptions that one cannot hope to emulate in one’s own company.

The dynamic capabilities school of strategists teaches that a company’s strategy should be primarily driven by its specific resources and competencies. Especially in periods of crisis, a company should find out how it can make small tweaks to its capabilities to meet new needs. Airlines, for example, have flexibly used their regular planes as quasi freighters. Office furniture companies have been creative in making their offerings eco-friendly and easy to install so as to meet the needs of the work-from-home segment. And in the hotel market, Red Roof started adapting its offerings through its Work Under Our Roof program: People who need a bit of quiet to get work done can rent out workspaces from 8 a.m. to 6 p.m. All of these examples demonstrate System 2 thinking that allows companies to not only address the current crisis but also look ahead to long-term competitive advantage.

The six situations described above have one thing in common: They illustrate how a thoughtful System 2 response based on sound economic and strategic logic can help executives make better management decisions about their offerings, prices, and cost management. Sadly, the COVID-19 pandemic has created highly visible opportunities to apply that logic and witness its impact quickly. But the underlying thinking should continue to prevail long after the world has conquered the virus.