Much has been written about pricing power, which is the ability to raise prices and have customers continue to buy from you. Disney, Netflix, and Pfizer have recently shown us examples of exercising their pricing power to improve their overall profitability. Last week, I was reminded of Martin Shkreli, an example of an egregious abuse of pricing power. It clarified how important pricing power is to increasing profitability, but also of the need to be judicious in setting or increasing prices.
An article in the Wall Street Journal, Martin Shkreli Steers His Old Company From Prison—With Contraband Cellphone cited the 5500% price increase implemented by Turing Pharmaceuticals on the drug Daraprim. (Shkreli was Turing’s CEO). Although the company’s profits improved, the shocking price increase angered customers and politicians, and it resulted in Shkreli testifying before Congress. His smug, unapologetic responses led to more investigations; and he is now in prison.
The article also reminded me of a conversation I once had with a woman who was a reservations agent for a major airline. She told me a story of a customer who called and wanted to fly from Indianapolis to a small airport approximately 90 minutes away. She told the customer the price and he was incredulous. He said, “I can fly to Los Angeles for less, and it is four times as far!” The agent said she then explained, “Sir there are several airlines who fly to LA, but we have no competition into this small airport. In other words, we have you by the balls.” She said the customer used the word “gouging”, but he understood and bought the ticket. I don’t know who the customer was, but I would bet any loyalty to the airline was gone. Another result was other airlines learned that route could be profitable with small planes, and there is now more competition serving that small airport.
In these two examples, pricing power came from monopoly-like situations. When you have no competition, you can charge whatever customers will pay, and your price will usually end up at the most profitable intersection of supply and demand. Although having a monopoly significantly increases your pricing flexibility, it is not the only source of pricing power; and most businesses have competition.
When you have dozens of competitors, there are limits on how much you can charge, but you still have some pricing power. The most important factor in determining how much you can charge, is how your product and service addresses a customer’s needs and wants relative to the customer’s alternatives. Consider the restaurant business, which is incredibly competitive. If pricing were the only criteria for selecting a place to eat, we would all eat at fast food restaurants; but we don’t. Ruth’s Chris, Capital Grille, and other fine dining restaurants charge $40 to $65 for a steak. The quality, freshness, and taste of the food, plus the service and overall ambience create a much more valuable experience. Consequently, the steak houses have more pricing power. If they increase their prices 10% on side dishes, or increase prices on wine 20%, it is unlikely to affect their volume.
There is usually a waiting list of people willing to pay more than $300 per person to eat at the French Laundry, a Michelin three-star restaurant in California. The quality and inventiveness of the chef’s creations are substantially different from the steak houses and more casual restaurants, and customers gladly pay a premium to eat there. That gives the restaurant pricing power. If they increase their price $25 per plate, customers will still come.
The different types of restaurants, from fast food, to casual, to fine dining, to Michelin-rated all have some amount of pricing power, but also some limits. Consider what would happen if any of them doubled their prices, instead of the modest increases I described. Customers would get angry. The fast food restaurants, who cater to the most price-sensitive customers would probably lose their customer base the quickest. Perhaps the French Laundry would still sell out each night, but the waiting list might disappear. The volume of customers at Ruth’s Chris and Capital Grille would drop significantly.
As another example, think about dentists. Once you have chosen your dentist, do you ever compare prices to other dentists in the area? Certainly, dentists have competition, but their customers (patients) prefer not to switch; and that gives the dentist some pricing power. But, what if your dentist increases prices to double the level of others in the area? If your insurance covers all the price, you may not care. But if you pay for any or all of it, you may be shocked when you learn your dentist is so much higher than others. And you will likely find a new one.
So, what is the point of all this? There are four points:
- Competition matters. Generally, the fewer competitors you have the more pricing flexibility you have. But it is important to compare yourself to the appropriate competitors for each customer segment. Although every city has a plethora of restaurants, there are substantially fewer fine-dining restaurants and only a very few Michelin-rated eateries.
- Even within very competitive segments, pricing power is determined by how well you address customers’ overall needs. If you have a differentiated service or product that better solves customer problems, you can get more for it.
- You can significantly improve profitability by exercising your pricing power – charging more where you can. Your pricing power may not be the same for all your products and services, so be the most aggressive on products with the lowest competitive intensity or your greatest differentiation.
- Everything has limits, even pricing power. If you wield pricing like a blunt instrument, you can shock and anger your customers, causing more long-term damage.
It is a simple concept, but it takes a disciplined approach. You may have more pricing power than you think in parts of your business. Use it where you can to improve your profitability, but don’t go overboard. And, don’t kill the goose that lays the golden egg.
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