What is “fair” pricing and a “reasonable” consumer surplus?

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In my previous blog, I discussed how to maximize returns through fair, value-based pricing. Value-based pricing is a pricing strategy that is based on creating differentiated value for the right, target customer segment(s) and capturing a fair share of the value created.  This begs the question, what is a fair share?

Even if you have a highly differentiated, value-added offer and are able to charge a premium without much customer pushback, your pricing should not aim to recoup the full value you create for your customers. Your price should leave a consumer surplus - that is, the customer should feel they are getting more value than the amount spent. Value perception is key to the sustainability of any good pricing.

Though the concepts of consumer surplus and value capture may seem arbitrary, that is not the case. How much of the consumer surplus you are able to and should capture is specific to the context within which your organization operates. In this blog I will discuss the best practices to determine what is “fair” pricing and “reasonable” consumer surplus.

How much value you can capture through your pricing depends on a combination of the following:

  • Pricing strategy - whether you want to optimize for revenue, profit or category share, market growth
     
  • Pricing power - how differentiated your offer is, and how easy it is for you to raise prices without facing customer pushback
     
  • Market dynamics - the competitive landscape, as well as the market forces of demand and supply that determine the price elasticity of demand and cross-price elasticity of demand.

Your pricing power and the market dynamics determine how much value you can capture. In other words, how much  consumer surplus you have to provide to your customers, based on the differentiation of your product/service and the competitive landscape. Your pricing strategy determines how much value you want to capture or how much consumer surplus you provide to your customers, given your pricing power and the market dynamics.

Pricing Strategy

Your organization’s immediate and long-term goals inform your pricing strategy - that is, whether you want to maximize revenues, profits or market share through your pricing.  So, for the same differentiated offer:

  • If you are optimizing for profit, then the focus is on capturing a higher margin, and therefore keeping a larger share of the consumer surplus for yourself

  • If you are optimizing for revenues, then the focus is on maximizing unit sales, so you would want to capture less value and offer a larger consumer surplus than if you were maximizing profits

  • If you want to increase category share, then the focus is on capturing and holding onto a bigger share of the market ahead of your competitors by offering a lower price, or more consumer surplus

Pricing Power

Pricing power is the ability of an organization to raise prices without facing customer pushback. Your pricing power is determined by:

  • how differentiated or value-added your offer is compared to your customers’ next best competitive alternative
  • how well your customers understand and value your differentiation

  • the degree of risk associated with adopting your solution (the more risk the lower your pricing power)

Value perception is the key to pricing power. Customers will always judge the fairness of your pricing by connecting the value of an offer to their perception of the price. So if you have a differentiated offer, it is imperative that  you effectively communicate the value of your offer to your customers. This is the only way to maintain your pricing power. Informed buyers have a higher willingness to pay, and you will be able to keep a larger share of the consumer surplus for yourself, should you choose to do so.

Having an undifferentiated offer means you have little pricing power, so you have to offer a larger consumer surplus. If you want to lower the consumer surplus, you need to create differentiation by addressing previously unmet customer needs, or by targeting a different customer segment where you may have more competitive advantage.

Market dynamics

Market dynamics also play a key role in how much of the consumer surplus you are able to keep for yourself. Market dynamics determine the price elasticity of demand and the cross-price elasticity of demand.

Price elasticity of demand measures the responsiveness of demand for your product or service to changes in price. Inelastic demand means that demand is not very responsive to changes in price. In such an instance, tweaking your pricing to offer more or less consumer surplus would be largely ineffective. Elastic demand means demand is very responsive to changes in price, in which case you may choose to tweak your pricing to offer more or less consumer surplus in alignment with your overall pricing strategy.    

Cross-price elasticity of demand measures the responsiveness of demand for a product or service to changes in price of another product or service. Substitutes have a positive cross-price elasticity, which means that increasing the price of one will result in a decrease in demand for the other. Within this context, if your strategy is to maximize market share, trying to capture more value and lower consumer surplus is not viable as it risks losing considerable market share. However, if your strategy is to maximize immediate profits, then you could choose a less conservative approach and raise prices.

 Figure: Consumer surplus for a differentiated offer in different contexts.

Figure: Consumer surplus for a differentiated offer in different contexts.

Putting it all together

Pricing is both science and art. You have to balance your pricing strategy and pricing power in the context of the market dynamics, to ensure you capture enough value to a) generate reasonable returns to your stakeholders and b) allow for investment into continuing innovation to maintain or grow your competitive advantage. All the while, you must provide your customers with the feeling they are getting their money’s worth. Prices are not static and neither are market dynamics. So even if you can get the balance  right today, make sure you regularly evaluate your pricing to ensure the consumer surplus continues to be “fair.”

 

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