Saturday, 19 September 2009

Pricing, utility and the four types of good

The Office of Fair Trading is conducting a market study on advertising and pricing.

This is of interest to me because one of my company's services is advising clients on how to structure their prices. Finding the right price structure is in the interests of both supplier and consumer; although pricing can look like a straight zero-sum game where any gain by the supplier is a loss to the consumer, this is not at all true in general. Thanks to the OFT for pointing out the study to me.

The authors have requested comments on what its scope should be; I have made the following submission:

Consumers' experienced utility of a good is not always predictable in advance, and pricing can be a key factor in several situations relating to this. Purchases can broadly be classified into four types:

In the first type, consumers have a good prior understanding of the utility they can expect to gain. This is the type of purchase dealt with by rational choice theory. Many of the pricing practices you propose to examine deal with this type of good. The key challenge for consumer protection in these cases is to ensure that consumers can clearly see the price, compare it with other offers in the market, and make the purchase that gives them maximum consumer surplus.

For example: a consumer planning a flight to Italy may know in advance that they are willing to pay up to £200. In this case the most important goal is to ensure competitive, fair comparisons between a flight costing £60 and another costing £80, so that the consumer has the ability to maximise their surplus. Another important consideration, though unlikely to arise in a competitive market, is to ensure the consumer does not unwittingly end up paying more than £200.

In the second type of good, consumer utility from the purchase is fixed in advance, but the consumer does not know what that utility is. In these cases, price is one of the most important signals on which buyers rely to predict their experience of the service. A restaurant meal priced at £59 is likely to be better than one priced at £19, and in the absence of other clear signals, consumers are likely to use that fact to help them make the best decision on which goods to purchase.

The third type of good is those for which consumers' preferences are not even fixed prior to the purchase. An example might be a buyer purchasing their first car; the use of the car itself is likely to invoke a brand loyalty in the mind of the consumer, affecting their preferences for future purchases. Price, once again, is a key influence on the shaping of consumer preference - with people often using the price of the product as one of the determinants of their preferences. Some consumers derive pleasure from the very fact that they paid £100 for their trainers, £300 for a meal or £1.2 million for their house.

Finally, the fourth type of good (or more often, service) is where the exact nature of the good itself is not determined prior to purchase. Many business services fall into this category; and the agreed pricing structure is one of the factors that influences the nature of the service that will be designed and delivered. For instance, if two businesses agree a 'structured pricing' model in which the supplier's reward will be a percentage of the profit made by the customer, then the supplier will be incentivised to provide a different kind of service than if they are paid a fixed price or an hourly rate.


My suggestion is to acknowledge within the scope of the study the differences between these four types of good or service. In the first type, it's usually clear that the consumer's interest is in achieving the lowest possible price, and the producer's interest in achieving the highest price. In the second, third and fourth types, consumer and producer interests are less clear a priori, and so the same factors and remedies will not always apply.
I am not sure if these four types cover all categories of good; readers' suggestions are invited for any major scenario that is not captured by them.

Tangentially, a few more or less relevant pricing-related posts are:
  1. Are hourly rates justifiable? by Ron Baker
  2. Krugman on ketchup economics from Consumerology (particularly the last paragraph or two)
  3. The Grand Unified Theory on the economics of free at Techdirt
  4. The price of Dan Ariely's Kiss from Curious Capitalist
  5. Calculating consumer happiness at any price in the New York Times

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