When a satisfactory price beats a maximal mark-up

Published: 
31 Jul 2017

This article is republished with permission from BusinessThink at UNSW Business School. You can access the original article here.

 

 

Firms that share their gains enjoy ongoing mutual benefits

Critics of big businesses often argue that they are too greedy and want to maximise profits at all costs – at the expense of their suppliers and customers.
 
New research casts a different light on pricing strategies, however, suggesting that many companies are conscious of the importance of equitable pricing as they seek to forge strong relationships with partners.
 
In their paper, Attention to fairness versus profits: The determinants of satisficing pricing, co-authors George Shinkle, an associate professor in the school of management at UNSW Business School, and Brian McCann, an ‎associate professor of strategic management at ‎Vanderbilt University, find it is “remarkably common” for businesses to set prices at “satisficing” levels.
 
That is, their strategy aims for a satisfactory or adequate return rather than a maximal profit level.
 
Shinkle stresses that such an approach is not due to the cognitive limitations of business bosses and managers.
 
“These firms knew they could have raised their prices,” he says. “It’s not that they did not know how to optimise pricing; they knew they were not optimising.”

Gain-sharing model

 
For their research, Shinkle and McCann tested survey data from more than 3200 firms across 15 countries, including consideration of institutional and cultural contexts of the businesses and their exchanges with customers and suppliers.
 
They found slightly more than 16% of the firms in the sample group were engaging in satisficing pricing, with managers of these firms indicating they could raise prices without losing any sales.
 
This proportion rises to 43% when the definition of satisficing pricing is expanded to include firms that could raise prices for their products or services and still sell the same or slightly lower quantities. Shinkle says in such cases a gain-sharing model is at play whereby companies and their customers treat each other well for mutual benefits.
 
“The companies recognised that if they take all the gains from the suppliers then the suppliers are not going to work so well in the future,” he says.
 
The authors also conclude that satisficing pricing is more likely in businesses that are located in countries with stronger cultural norms that encourage fairness, altruism, friendliness, generosity and kindness to others.
 
McCann reiterates that these pricing decisions are not the result of “dumb” or “lazy” managers.
 
“We really do think this reflects the fact that decision-makers are trying to balance multiple objectives in making business decisions like setting prices,” he says. “Yes, companies are interested in the pursuit of profit, but that pursuit is often bounded by norms of fairness and reciprocity.”
 
The research identifies key factors associated with satisficing pricing. Perhaps not surprisingly, companies that are performing well relative to their competitors are more likely to be unselfish.
 
“We also think this type of pricing behaviour is driven by reciprocity, and our research indicated that companies whose suppliers set satisficing prices to them were more likely to ‘pay it forward’ to their own customers,” McCann says.
 
“And companies whose customers tended not to pressure them for cost-price reductions tended to ‘pay it back’ to those customers with satisficing prices.”

Seen to be fair

Despite the importance of pricing strategies for business success, David Knowles, executive director of Pitcher Partners’ International Institute of Entrepreneurship, says many companies are guilty of “accidental” planning.
 
Part of this phenomenon is that they tend to set prices based on what the market will allow and knowledge of what their competitors are charging.
 
“A lot of price-setting is in relation to how you want to be perceived among your competitor set,” Knowles says. “Whether or not you’re followers or leaders on pricing, or otherwise differentiating yourselves by way of using price as a signal; for example, to point to quality.”
 
He concurs with the findings in Shinkle and McCann’s paper that satisficing pricing is quite common.
 
“You’ve got to be seen to be fair to do business. It doesn’t matter how big the town is … your reputation precedes you when you’re dealing with your customers. If you gouge or take advantage of your customers for a short-term opportunity, it gets remembered.”
 
In addition to not wanting to be seen as greedy, Knowles says smart businesses are eager to ensure their long-term sustainability. To that end, maintaining strong alliances with suppliers and customers makes sense. He believes private businesses are most likely to pursue satisficing pricing as they typically have a longer-term focus compared with public companies with shorter reporting cycles.

Influence of culture

Shinkle and McCann acknowledge considerable research showing that institutional environments influence the attention and behaviour of firms and that managers often act according to the social values and norms of their environment. Other research also reveals that national culture can have a profound impact on strategic decision-making.
 
Shinkle says his personal experience working for Toyota provided evidence of satisficing pricing. The automotive giant is renowned for working closely with its suppliers through a gain-sharing model, which is in contrast to the actions of many businesses that follow the economic norm of chasing the best price in highly competitive markets.
 
Knowles agrees that Toyota and other Japanese conglomerates are prime exponents of satisficing pricing and that they typically “play a long game. They do take a 50-year view of the world,” he says.
 
According to McCann, formal institutions such as legal frameworks, property rights and regulatory regimes also set the tone for managerial strategies.
 
Consistent with this argument, he and Shinkle found that satisficing pricing behaviour was less likely in countries with greater institutional development and that the culture of a country – for example, the attention or lack thereof on values such as fairness and altruism – could influence business strategies.
 
“Economic behaviours, like pricing decisions, can be influenced by that culture,” McCann says.

The role of managers

Shinkle and McCann’s findings have implications for practising managers, who should be aware that aspects of social context, including formal and informal institutions, influence pricing decisions.
 
McCann says there are also some important implications for multi-location firms: “If you have different locations setting prices in different contexts, you may end up with some differences in prices due to that. If that's a problem, a higher degree of control over pricing may need to be exercised.”
 
Knowles advises managers to consider the keys that drive value, including return on investment and risk, and take a long-term view of supply chains. He notes that ‘born-global’ companies such as Google and accounting software enterprise Xero have succeeded on the back of trade-offs with pricing, initially sacrificing profits to invest in their businesses’ customer bases and later cashing in when they have a strong market share.
 
This differs from traditional pricing models where companies have tried to be profitable from day one and reinvest profits to grow.
 
“The Google and Xero approach is a very strategic way of doing business and it’s quite different to what the model would have been 30 to 40 years ago,” Knowles says.
 
Shinkle concludes that “bounded self-interest” – or pursuing economic objectives along with fairness and reciprocity – should be top of mind for business decision-makers. Those who share their success with others may be more likely to perform well in the long-term.
 
“Even though some firms sacrifice profits to achieve what they see as fairer outcomes, others may achieve higher profits in the long run by satisficing prices. The idea is that you are in a social ecosystem and if you treat your customers and suppliers in a more positive way, it may lead to a better future position for you,” Shinkle says.
 
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