Charging prices that are fair and profit-optimal seems like a contradiction in terms. The pricing maxims of “extract full value” and “maximize profits” are not exactly customer friendly. A “fair price,” meanwhile, is not only a fuzzy concept that defies definition under classical economics. It is also an intensely visceral concept for primates – and by extension, humans – as this humorous TED Talk video by Dutch primatologist Frans de Waal shows.
When future Nobel Prize winners Daniel Kahneman and Richard Thaler teamed with the late economist Jack Knetsch to explore fair prices back in the 1980s, they concluded that “in customer or labor markets … it is unfair to exploit shifts in demand by raising prices or cutting wages.” In other words, everyone hates it when the price of a snow shovel triples after a blizzard hits or when wages get slashed amidst a recession.
But what about everyday prices when there are no natural disasters or macroeconomic effects to distort supply and demand? What makes those prices fair, and how should business leaders use that information?
BCG’s Henderson Institute (BHI) has conducted extensive global research into the questions of price fairness. The results have led my colleagues and me to a powerful but controversial conclusion: the fairest prices – not the highest prices – optimize profits for a business.
Needed: A robust definition of a fair price
Implementing that idea depends on having a robust and actionable definition of a fair price. To establish that, we began by ruling out commonly held ways to define the term.
- Is a fair price the same price for everyone? Uniform prices make intuitive sense. But the BHI research showed that people still find it fair when others pay lower or higher prices for the same offering in many real‐world scenarios. If you are American, you probably feel it is fair for seniors to receive discounted hotel rates. If you are French, you don’t. People in India and Japan feel that time of day is a fair rationale for offering discounts for gasoline, but the Germans, French, and Americans tend to disagree.
- Is a fair price one that is accepted by both parties? That definition holds as long as the context of the transaction doesn’t change. But what if a buyer finds out a week later that their next-door neighbor or their toughest competitor bought the same product from the same seller at a much lower price?
- Is a fair price one that is set by the free market? The idea that supply and demand leads to fair outcomes permeates economic thinking. But the free market often leads either to uniform prices, to the kind of gouging that Kahneman, Thaler, and Knestch studied, or to regressive prices that entrench biases. Minorities and women, for example, tend to pay higher prices for cars. Less wealthy patients tend to pay higher prices for medications.
We ultimately arrived at this robust definition of a fair price: one that shares value equitably between parties. The total value that buyers and sellers can share is the difference between customer value and variable costs. The position of the price within that range defines how the two parties will share that value. The buyer earns the surplus, which is the difference between customer value and the price. The seller earns a gross profit, the difference between the price and the variable cost, as the figure below shows.
The heretical question: How much money should you leave on the table?
A price that shares value equally across buyers and equitably between buyers and sellers may seem counterintuitive under classical economics. But it turns out to be a more effective way to serve the goal of classical economics – higher profits – than conventional pricing approaches.
There is a big difference, however, between leaving money on the table inadvertently and leaving money on the table purposefully. The former is still a mistake. It’s the latter case that we advocate. Business leaders seeking to charge fair prices should view “leaving money on the table” as an opportunity to seize, not a mistake to avoid.
Our subsequent research has shown that the margin‐optimizing share of seller value is around 50% of the total value. But the seller’s optimal share varies significantly by country, the amount of value at stake, the industry, and whether the transaction is B2C or B2B.
- By country: The seller’s optimal share of value may be higher in countries such as India, China, or Brazil, which have higher average levels of perceived fairness.
- By absolute value: The share decreases as the absolute value at stake increases, unless the product has both high absolute value and a unique value proposition.
- By industry: The share is closer to 20% for B2B products, because customers tend to be much more sensitive to the amount of value the seller retains. Technology companies often choose to retain only 10% of the available value, thus sharing 90% or more of the value with customers and channel partners. One motivation behind this conscious choice is to gain market adoption as fast as possible.
We devote two full chapters of the Game Changer book to the topics of price fairness and equitable pricing.
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