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 price models, 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.)
photo credit: » Zitona «
First, the basics.
What are sticky prices?
Sticky prices, also known as price stickiness refers to pricing that is resistant to changing market conditions. In other words, even if it is economically optimal to adjust prices to meet demand, businesses are reluctant to do so based. Sticky prices exist in markets with imperfect information, lack of competition, or heavy regulation.
photo credit: Swami Stream
The best examples of sticky prices
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.
Sticky wages theory
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. A change in wage 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, I hate to break it to you!). Inflation and unions also mean 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 a 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 known 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 times 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 set new 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 lose out on profit that could have been generated with a price change. Many businesses have traditionally refrained from changing them out of fear ofr 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.
How to make prices less sticky and maximize 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 uses 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. The price optimization software is great for this, but even simply picking up the phone will do.
4. C is for communication
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 decide when to alter their prices and when to keep them 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 into 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!
Sticky prices FAQs
What causes sticky prices?
Sticky prices are often caused by volatility in the inflation rate, be it expected inflation, temporary inflation, or wage push inflation. It can also be caused by markets that have imperfect information, heavy regulation, and lack of competition.
Are sticky prices good or bad?
Whether sticky prices are good or bad depends on the context. While items like gas are free to adjust in accordance with market demand, labor costs benefit from being less sticky due to regulation and provide economic stability in the midst of economic fluctuations.
What is the difference between sticky prices and flexible prices?
Sticky prices are often triggered by an impediment or a change in cost and cannot fluctuate easily. On the other hand, flexible prices are more susceptible to change as they adapt to market conditions.