I recently read the paper “An Economist Sells Bagels: A Case Study in Profit Maximization” by Steven D. Levitt, author of Freakonomics and economics professor at the University of Chicago. (Pardon me for not typing the full text of his title)
As usual for Dr. Levitt, the paper is very well written in a way most people can understand. The paper’s most important point was the necessity of feedback on prices. In his paper, Dr. Levitt describes how an economist turned bagel salesman captured and evaluated significant details regarding the volumes and types of bagels and donuts that were sold. He was getting daily feedback on volumes. An opportunity to evaluate the effect of pricing decisions (by looking at the impact of price changes) appears to have been ignored, resulting in missed opportunities to maximize profits by raising prices.
It seems to me that the bagel economist’s allocation of effort, lots of analysis on volume and much less on pricing effectiveness, occurs at other companies all the time. Because it is difficult, too often companies avoid capturing and analyzing the important feedback on their prices. Instead they rely on anecdotes, gut feel, and rules of thumb for margins to set their prices. So if it is hard, how should companies get the feedback on their prices? This is a very simplistic response, but:
- First they need to make sure someone’s job responsibilities include measuring pricing effectiveness.
- Next that person(s) needs to appropriately segment their customer base. It is important to have peer groups (segments) to look at, because when individual product volumes change, they will want to see if the volume changes are common within a peer group or not.
- Third, they need to measure as much as they can at the most granular levels they can handle. So that means the companies must build analyses to isolate price as a variable impacting volumes, as opposed to lumping it in with all other variables. Transaction-level details in appropriate segments will help get there.
- Last (in this simplistic answer), companies need to experiment. Make small price changes in certain customer groups or products or customer/products and evaluate the impact. Try to determine how elastic or inelastic those customers or products are in the tests, and build confidence for broader price moves.
Obviously the world is complicated and those four points are fairly simple. But companies can and should take some steps to get and evaluate feedback on their pricing. If a firm finds that on average 20% of its products are underpriced by 5% because they relied on anecdotes rather than getting empirical feedback, there is a 100 basis point improvement in margin just waiting to be earned. Perhaps that is worth considering over a bagel.
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