September 19, 2012
Sticky Prices 101: The Necessities and Your Pricing Strategy

Post-it notes, sushi rice and the gum a second grader stuck in my hair last week are a few things we categorize as “sticky.” Just as it took me over an hour to get that nasty mess out of my hair (peanut butter doesn’t actually work), stickiness as a concept has provided similar frustration to economists. That’s right, prices too can be “sticky.” It means exactly what it sounds like; sticky prices don’t adjust as quickly as they should according to the laws of supply and demand.

Let’s explore this concept of sticky prices, uncover why these prices won’t budge, before finally revealing some ways to make your prices less sticky (HINT: Less sticky prices mean more revenue for you.)

Pricing Strategy

photo credit: » Zitona «

First, the basics. What are sticky prices?

Sticky prices exist when prices do not react or are slow to react to changes in demand, production costs, etc. For instance, if tomato prices plummeted, Chef Boyardee would more than likely not lower his prices, even though his input costs decreased. Instead, he would simply take the greater margin as profit. Consumers see no difference in price, even though it should have been changed according to the classic laws of supply and demand. This works the other way around too. Just because the price of tomatoes went up doesn’t mean Olive Garden hikes up their spaghetti prices.

Value Based Pricing

photo credit: Swami Stream

While stickiness has played tricks with both lowering and raising prices, some goods and services are sticky up or sticky down. That means that while they move in one direction easily, getting them to reverse the trend is extremely difficult. Wages is a great example. People are generally pretty happy when they receive a pay raise, but pay cuts are rare, because your boss is more likely to lay you off or cut your hours than change your pay (sorry, hate to break it to you!). Inflation and unions also means that workers are used to and expect their wages to grow over time through legislative or membership pressure, making these “prices” sticky down, where a decrease is unlikely even when it is in the long term interest of the firm and the employee.

OK, I get it, but I can change my prices whenever I want...or can I?

From a pure efficiency standpoint, sticky prices are an abomination, because holding an inefficient price results in deadweight loss since the market suggests there is another optimal price to maximize consumer and producer surplus. However, there are a number of reasons why businesses do not change their price as often as Kim Kardashian has a new boyfriend. Let’s take a look.

“Menu Costs” can be expensive

Menu costs, also know as “the cost of updating prices” can be high depending on your industry. Imagine if you ran a restaurant and printed new menus every time the price of corn changed. Given the mess of our agriculture industry, the time, energy, and cash needed to change the menu dozens of time per day would add up and outweigh the benefits of a better price. In other markets (software and SaaS in particular), menu costs could include hiring pricing consultants and updating computer systems. Price stickiness can also be attributed to imperfect information and non-rational decision making, even if you’re willing to update your prices every five minutes.

It’s a Tough Decision that can annoy customers

Changing prices could theoretically maximize profit, but fluctuation in prices can confuse and annoy consumers. We’ve all been in this situation before, and like most consumers, we don’t react well to seeing something we bought available at a lower price the next day. At the same time, however, some businesses are too cautious and are losing out on profit that could have been generated with a price change. Many businesses have traditionally refrained from changing them out of fear for antagonizing consumers to move to another brand. Coca Cola didn’t update its prices for 70 years after introducing our favorite, polar bear sipping beverage.

Why should you care and how can you make your prices less sticky to maxiize revenue?

All of this is great to know, but really you’re here to figure out how you can help your business by making your prices less sticky. There are three main ways:

1. Understand your costs and where your costs come from

Next to not knowing your customer’s willingness to pay, not knowing your costs is one of the worst things you can do in business. Yes, there will be some murkiness with calculating overhead costs, but you need to know the ballpark level of your costs. Additionally, you need to know where these costs are coming from, so if you see a major shift in an input cost, you at least know the impact and whether you need to hedge against the shift. This knowledge has allowed some businesses to take the flat rate approach, such as JC Penney’s new pricing strategy that we previously blogged about.

2. Align your business model to usage and value

The best way to loosen your prices is to ensure that once you align your business model around usage and your costs of doing business. We chatted a bit about this in our blog post on optimizing the pricing page, but take a look at Wistia, a company that hosts businesses’ videos. Their bandwidth costs are (more than likely) enormous each month, but one of the key value metrics they charge customers on is bandwidth used. In this manner, they ensure that if someone used an extraordinary amount of bandwidth, they are charged accordingly.

3. Gather data on customer value to know how far you can push the price

You must, must, must know what your customer’s willingness to pay is for your product(s). This is just a cardinal rule of pricing, in general. You may not charge them at the top end of this range, because of different contributing factors (although you’ll technically be losing money), but you’ll at least know where you can push the price. Price optimization software is great for this, but even simply picking up the phone will do. 

4. C is for communicate

We wrote about how consumers tend to understand price changes or price conversations in a price optimization article on communication. Yet, understanding your customer and communicating honestly with them bears repeating. Price changes happen, and consumers understand, especially when justified to them.

Not all prices are sticky; those giant white billboards at gas stations display different numbers every time I drive past. Depending on the sector, businesses have to make the important decision of when to alter their prices and when to keep it constant. It’s a balance, and either way the see-saw turns, it is important to be aware of the phenomenon of stickiness and understand its effect on any pricing strategy.

Also, to dig deeper on developing your pricing strategy check out our Pricing Strategy ebook, sign up for one of our (free) price optimization assessments, and take a gander at our price optimization software. We're here to help!

comments powered by Disqus