Thursday, April 25, 2013

Unsustainable Pricing

A series of clicks today led me to this YouTube video of Senator Warren's March 2013 congressional hearings on the minimum wage.

At 2:53 she notes as a result of an increase in the minimum wage to $10.10/hour over three years, the price of a fast food meal would rise by four cents.
So instead of it being $7.19 it would be $7.23. Are you telling me that's unsustainable?
Given the context, "unsustainable" probably refers to the restaurant business itself. As in, "if you raise your price by four cents, are you really going to have issues?"

The answer is yes.

There is a nasty consumer habit to believe that the prices we see are given, as if they were determined randomly or granted to us from a deity. But they are the careful, careful decision of business owners and analysts with the sole aim at maximizing revenue. The $7.19 price came from a conversation like this (all prices are post tax):

"How about $7 for the meal?"
"$7 is a bit low; I bet we can up our revenue if we increase by two quarters."
"Our market research tells us our consumers are particular price sensitive, especially given the state of the economy. I wouldn't go higher than $7.05."
"Really? We can definitely go higher than $7.05. I was thinking $7.40."
"No way! Our competitors' are pricing lower than that. We gotta go much lower."
"Our competitors price there for a reason."
"A TV dinner only cost $5. This is our competition."
"It isn't nearly as easy, nearly as good. When we offered a coupon last year, people barely used it. We can afford to go higher. We have investments to pay off."
"How about $7.35?"
"Burger King's $7.25."
"It also's been hitting the airwaves harder than us. Let's drop a little below them and get our customers through price."
"A little bit more; something big enough that they just can't respond."
"$7.17? Has a nice ring to it"
"Maybe...or $7.20"
[Market research]
"$7.19 seems to be the sweet spot."

This is an abstraction, (void of uncertainty which is another factor they consider but I need to go to bed) but it's meant to remind us that firms do not grab numbers from nowhere, especially for firms who tend to sell very cheap food and where customers are very sensitive to price. Warren's thought process seems to be "Well, I'd pay 4 cents more while on my campaign trail" but she is a wealthy individual with very little time and not many alternatives: it's hard to get more insensitive than that.

Many customers, especially when times are tough (and thus when  increasing the minimum wage is most popular), are very price sensitive. This goes double after a lot of time has passed and they can adapt to the 4 extra cents (which, for a family of four and a biweekly meal out totals to $16.64 over the course of a year) in ways such as going to restaurants with fewer minimum wage workers (and thus less of a price increase so at least you get more for your money) to eating at home more to eating less when you do eat out.

At the heart of Warren's question is a puzzle: if an extra four cents is so sustainable, why isn't it already four cents more expensive?

It's because it is. That's the revenue maximizing price.


CalLadyQED said...

Sorry, why would they want a revenue-maximizing price? Shouldn't they be trying to maximize profits?

David said...

Yes, they do. But for simplicity, the price which maximized revenue is the same as the price which maximizes price.

Is this actually true? No; the lower the price, the more you sell and the cost to create each item changes based on how many, in total, you make. But for purposes of this post, it seemed clearer to talk in terms of only revenue.