Value-based Pricing: Fair or Foul?

As Accenture describes in a recent book on ‘Contextual Pricing: The Death of List Price and the New Reality’, the growth of big data provides companies with unprecedented opportunities to personalise their products, services and experiences for customers. Armed with detailed knowledge about individual customers, the products they have, their recent behaviour and what they are doing right now, companies can use contextual marketing to pitch exactly the right product at exactly the right price to the customer in their current circumstances.

Increasingly, the price will depend on how much the company thinks the customer is willing to pay for the product in their current circumstances. A fire extinguisher is more valuable to a customer whose house is burning down than to one whose house isn’t. So – metaphorically speaking – why not charge more for it when the house is already alight. The customer may be offered the same fire extinguisher at different prices in different circumstances.

This type of ‘value-based pricing’ brings two groups in direct conflict with each other. In the blue corner are the economists with their emphasis on market-driven pricing, whilst in the red corner are the moral philosophers with their emphasis on justice theory.

The Economist’s View: Context Trumps Fairness

Ask an economist about value-based pricing and he will likely tell you that pricing is the way that markets set the value of a product. The more valuable a product is, the higher its price will be (assuming a fixed supply of the product). Just like the customer whose house is burning down. In pricing, context is everything.

There is no economic reason why a person with a greater contextual need for a product should not be charged more than someone with a lesser need. This is the simple economic principle behind the widespread use of yield management by airlines, cruise lines, hotels and companies with seasonal, perishable or variable value assets.

The Philosopher’s View: Fairness Trumps Economics

Ask a moral philosopher about value-based pricing and he will give you a very different answer. Value-based pricing is fundamentally unfair and easily leads to moral outrage. Amazon was roundly pilloried in the business press for its early experiments with variable DVD pricing based on customers’ previous purchasing history.

Taken to an extreme, value-based pricing can result in prosecution through price-gouging laws. The State of New Jersey has prosecuted hundreds of hotels, petrol stations and building suppliers for price gouging in the wake of Hurricane Sandy. However, some economists believe that price gouging is not only fair, but reduces essential shortages in emergency situations. The issue of price-gouging has sparked a fierce debate in the aftermath of Hurricane Sandy.

When Does Value-Based Pricing Work?

The rapid increase in the availability and use of big-data suggests that value-based pricing will also increase in usage. The conditions under which it works best are well understood. Werner Reinartz sets out five conditions in a paper on ‘Setting Prices in an Online World: When Price Customisation Works (And When it Doesn’t)’. And it does work; airlines are estimated to increase their revenues by 4-6% and hotels by 3-5% through yield management, without increasing their operating costs.

But it also has an impact on customers’ perceptions of fairness. Kees Correia Nunes da Silva shows in a paper on ‘The Impact of Yield Management in the Airline Industry on Customers Feelings of Price Fairness’ that customers feel unfairly treated when airlines extract higher prices through yield management rather than through developing closer relationships with them. The curious thing is that a number of studies show that the relationships built through frequent flyer programmes increase revenues by significantly more than those available through yield management; by 6-14% of the average fare paid.

Should customers in the most need be charged higher prices? That’s may be good for sellers but it’s not so good for customers. Or should all customers be charged the same price? That’s good for customers but it’s not so good for vendors. As the witches in Macbeth cry, “fair is foul an foul is fair!”

What do you think? Is value-based pricing a fair economic model? Or is it a foul affront to our moral sensibilities?

Graham Hill @grahamhill