The Spirit of Giving

Merry Christmas!

Joyeux Noël!

Sheng Dan Kuai Le! (圣诞快乐!)

Wishing you an enjoyable day, and a happy holiday season spent with good people, surplus amounts of food and drinks, and a large number of gifts!

One idea that is firmly associated with Christmas is gift giving. This is a central part of the Christian tradition, and also has an important place in broader Western culture, which retailers are obviously happy to encourage and embrace.

The festive season’s spirit of giving provides us with a nice opportunity to revisit basic notions of “value”, “price” and “cost”.

the-spirit-of-giving-2

We can think of “value” as the benefit provided by a good or service to the end user.

Economists typically interpret this as the consumer’s “willingness of pay“. That is, the maximum amount that a consumer would be willing and able to pay for a good or service. This allows them to introduce the idea of “consumer surplus“, which is the difference between willingness to pay and the actual price level. And the notion of consumer surplus leads to the idea of “gains from trade“; the idea that both consumers and producers can be made better off if they are allowed to trade freely.

Christmas gives us a chance to re-examine this mainstream interpretation of “value”.

It is evident at this time of year that a gift’s value is often totally disconnected with how much the recipient would have been willing or able to pay for it.

Factors that might affect the value of a gift include:

  1. The strength of the relationship between the giver and receiver of the gift;
  2. Whether or not the gift is a surprise;
  3. How well the gift matches the recipient’s needs and interests;
  4. The message on the card;
  5. The decorations surrounding the gift (Xmas tree, stockings, reindeer, Nativity scene);
  6. The colourfulness of the packaging;
  7. How fun or difficult the packaging is to rip open; and
  8. The atmosphere, experience and ritual of opening gifts together with family and friends.

Christmas is a time of year when people go to great lengths to maximise the value of what they give to others, so much so that it shatters mainstream Economists’ interpretation of “value” as “willingness to pay”.

Next we can consider “price” (what a firm receives from a customer (who may or may not be the end user) in exchange for a good or service) and “cost” (what the firm needs to pay for inputs that are used to produce it).

When I studied Economics as an undergraduate at Sydney University (under such luminaries as Kunal Sengupta, Tiho Ancev, and Don Wright) it was explained to me that firms aim to maximise profits. They can do this by adjusting price and quantity in order to increase the distance between total revenue and total cost. At a minimum, I was told, they will never set a price which is lower than the average cost of producing one extra unit (that is, price will never be lower than variable cost).

At Christmas, people spend significant resources (time, money, effort, imagination) to purchase or create gifts which they then give away for free. People tend to hunt for the best “value” gift that they can find within a given budget. That is, they seek to maximise the gap between “value” and “cost”, not “price” and “cost”.  Christmas shoppers will often hunt for a bargain, but if they stumble upon a remarkable gift which exceeds their budget they will often buy it anway.

“This is far too expensive! Meh, it’s Christmas! I’ll put it on my credit card!”

Your response might be that a firm is not a family, and so this Christmas analogy is invalid.

But is it?

What would the world be like if firms thought of consumers like family members?

And, more to the point, how did many of today’s most valuable technology firms become billion dollar companies? Think of Whatsapp, Twitter, WeChat, and Facebook. They did it by trying to provide value for as many end users as possible, and only afterwards did they find a business model to sustain and grow the firm.

Merry Christmas!

Joyeux Noël!

Sheng Dan Kuai Le! (圣诞快乐!)

Image: Tom Spencer

Price and Value

Price and value, there is a difference.

Price is what you pay for something; the number of dollars that you need to part with in order to obtain it. Value is what you receive; the positive feelings or practical utility that the object or the experience imparts.

I recently had my birthday, and I was delighted to receive a wonderful birthday present from my family in Sydney.

I logged onto Facebook in London, and found that my family had posted the following picture.

Price vs Value

The price of a piece of cardboard and some crayons: $1.

The value of receiving a “Happy Birthday Tom!” poster from all the family: priceless.

Four P’s Marketing Framework

A useful framework for evaluating the marketing strategy for a product

Four P Marketing

THE Four P’s consists of:

  1. price ;
  2. product ;
  3. position/place; and
  4. promotion .

1. Price

The pricing strategy employed by a firm for a particular good or service will have a significant effect on profit.

There are many different pricing strategies that can be employed in different combinations, including:

  1. Price differentiation – setting a different price for the same product in different segments of the market. First degree price discrimination involves charging each customer a different price. To do this, the seller must be able to observe each customers willingness to pay, this is very difficult to do in practice. Second degree price discrimination involves varying the price according to quantity sold. Third degree price discrimination involves varying the price by location or market segment. For example, charging discounted prices for students.
  2. Dynamic pricing – a form of first degree price discrimination, dynamic pricing is a flexible pricing mechanism that allows online companies to adjust the price of identical goods to correspond to a customer’s willingness to pay. This is made possible by using data gathered from a customer including where they live, what they buy, and how much they have spent on past purchases.
  3. Predatory pricing – aggressive pricing intended to undercut competitors and drive them out of the market.
  4. Limit pricing – a low price charged by a monopolist in order to discourage entry into the market by other firms.
  5. Using a loss leader – a loss leader is a product sold at a low price to stimulate other profitable sales. For example, the 30 cent soft serve cone at McDonalds.
  6. Penetration pricing – the price is set low in order to gain market share.
  7. Marginal cost pricing – the practice of setting the price of a product equal to the cost of producing one extra unit of output.
  8. Market-orientated pricing – setting a price based upon analysis of the targeted market.
  9. Psychological pricing – pricing designed to have a positive psychological impact. For example, selling a product at $3.95 instead of $4.
  10. Skimming – charging a high price to gain a high profit, at the expense of achieving high sales volume. This strategy is usually employed to recoup the initial investment cost in research and development, commonly used in electronic markets when a new product range is released.
  11. Premium pricing – involves keeping the price of a good or service artificially high in order to encourage a favorable perception among buyers.
  12. Target pricing – a method of pricing whereby the selling price of a product is calculated to produce a particular rate of return on investment.
  13. Seasonal pricing – adjusting the price depending on seasonal demand.
  14. Cost-plus pricing – a very basic pricing strategy where a firm sets price equal to unit cost of production plus a margin for profit.

2. Product

Product differentiation is a source of competitive advantage. Product differentiation is the process of describing the differences between a good or service in order to demonstrate the unique aspects of the good or service and create an impression of value in the mind of the consumer.

The major sources of product differentiation include:

  1. Vertical differentiation –where products differ in their quality. For example, BMW and Hyundai.
  2. Horizontal differentiation – where products differ in features that cannot be ordered. For example, different flavours of ice-cream.
  3. Availability – where products are available at different times (e.g. seasonal fruits) and locations (e.g. location of an ice-cream store near the beach). See section 3, “Position/Place”.
  4. Perception – branding, sales, and promotion can be used to distinguish a product in the market. See section 4, “Promotion”.

Successful product differentiation leads to monopolistic competition. In a monopolistically competitive market consumers perceive that there are non-price differences between products. As a result, even though there are a large number of producers, each producer has a degree of control over price.

3. Position/Place

The physical location of a good or service can be a source of competitive advantage. For example, imagine we have two ice-cream stores. One ice-cream store (Store A) opens next to a popular tourist beach, and one ice-cream store opens in the backstreets of a quiet suburb (Store B). We expect that Store A will be able to charge a higher price and sell more ice-cream than Store B, other things being equal.

4. Promotion

Promotion is used to enhance the perception of a good or service in the minds of consumers. A promotion will draw peoples attention to any features of a product that people might find attractive including its quality, specialised features, availability, brand name, or image.

Promotion can be carried out in various ways including:

  1. advertising (developing brand awareness);
  2. publicity (sponsoring a sports team);
  3. public relations (donating to charity);
  4. celebrity appearances;
  5. door to door sales;
  6. price discounting (see section 1, “Price”); and
  7. quantity discounting (two for one offers, bundling).

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]