How not to rip off your customers

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The title of this post surely seems somewhat strange. Surely any self-respecting business should be in the interest of making as much profit as possible, and the temptation might be to extract as much as you can from each customer interaction. But we know that such views can be too short-term. In many situations, while you could rip off a consumer when they first walk through your door, if you want them to come back, you need to them to be happy with the outcome — including getting “value for money.” This problem is as real for consumer-centric organizations as for corporations looking for opportunities to share value beyond their shareholders (asMichael Porter and Mark Kramer recently discussed in the pages of HBR).

Sharing value is perhaps a straightforward proposition when it comes to not dumping pollutants into the environment or skimping on product quality in ways that harm your customers’ health. But how does it work with regard to rip offs? That is, how exactly do you price so that you consumers feel happy and come back for more?

Northwestern University economist Jeff Ely addressed this question in a series of (somewhat technical) blog posts. Ely was concerned with situations in which some consumers value a firm’s product more than others, but the firm can only supply so many consumers. Which is to say, there isn’t enough product to go around, a classic rationing problem. Ely’s example used a popular restaurant, but it could apply equally to, say, a Broadway show. It could also apply to companies who launch new products to long queues (ahem, Apple) rather than pricing high to early adopters.

Firms do not usually consider having a scarce but desirable product a problem. Firms that want to make profit should run an auction and offer their product to the highest bidders. But as Ely pointed out, that means pitting your customers against one another with a result that those who actually get the product will pay a high price while others miss out entirely. In that situation, those who end up with the product might not be left with much value, and may feel ripped off, even though they chose what to pay. In the long run, the firm may face issues if they need to dip again into that customer pool. They clearly like the firm’s products but may have ill feelings about having paid so much. Perhaps this isn’t an issue for a Broadway show, whose customers tend to be one-offs, but for a local restaurant it is real.

One way to resolve this is to just set a price. If you really cared about the value consumers get, you’d price at cost and ration randomly amongst those willing to pay more than cost for your product. But for any firm, this is a heroic amount of sharing of value. Your consumers get as much as possible but you just cover costs.

You could charge more than cost, but this creates another dilemma. When there are lots of consumers with high values around, you’ll sell out. But what happens if those consumers aren’t there? Set a price and you are left with spare products. For a restaurant or concert venue, the extra seats do not paint a pretty picture.

Ely suggests that firms could deploy a hybrid between a price and an auction: hold an auction but cap the maximum bids that can be made. When demand is high, you’ll end up rationing but no one will be ripped off. But when demand is low, your price will effectively drop and you’ll still be able to sell out. You use the auction precisely when your consumers have power — so enable them to exercise that power.

This outcome is not as strange as it might sound. For one, it explains why concert venues don’t price so high that scalping markets are killed off. It also explains why promoters don’t like those markets. This is something that has long been puzzling to economists. Indeed, Ely goes further and advocates for a system whereby firms have either refundable tickets, so that those who think they have paid too much can exercise regret, or alternatively, their own official resale market but with a capped bid.

Some have expressed skepticism that firms are sharing value. But the fact is that we see rationing mechanisms that start with relatively low prices and rarely go higher when demand is high. Moreover, we also see companies that time and again tolerate rationing for popular products. This suggests those firms place some weight on the value their customers actually get Think about that the next time you are standing in a queue for the latest Apple gadget. Maybe they care.

Joshua Gans is an economics professor at Melbourne Business School and a visiting researcher at Microsoft Research (New England). All views are his own. While writing this post in a café, the owner randomly gave him a free cookie.

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