Author: Hermann Simon

The rapid spread of the Coronavirus is causing uncertainty for consumers, suppliers and markets. Consumers decry increased prices in the face of a crisis, but suppliers are working to meet increased demand and prevent scarcity at a more rapid rate. Emergency situations call for emergency pricing responses, but what are the best responses for all concerned? In this article, the author explores the pricing complexity and ethical considerations pricers face in these types of situations. Professor Hermann Simon is Founder and Honorary Chairman of Simon-Kucher & Partners. He is also the author of Price Management: Strategy, Analysis, Decision, Implementation. He can be reached at hermann.simon@simon-kucher.com.

The Pricing Advisor, March 2020

Price Ethics and Corona

The corona crisis is causing uncertainty and fear. Products such as protective masks, disinfectants, and certain types of medicines are sold out. The demand for everything that can be useful if the crisis worsens is exploding.

In a free market economy, price increases are the consequence of such a sharp increase in demand. The suppliers of scarce goods ask for higher prices, and these price hike cause buyers to become angry and indignant. Price gouging is perceived as an unethical exploitation of an emergency situation and is therefore met with broad rejection.

This is by no means a new problem. The philosopher Thomas Aquinas (1225-1274) dealt with it and developed the concept of “just price.” His ideas were influenced by the traditional Christian attitude against usury and against charging interest in general. In his world view, raising prices in response to increasing demand is theft. He classified price increases in the wake of natural disasters as extremely unethical.

But things are not quite so clear. If sellers keep prices constant, the fastest consumers will empty shelves, hoard products and, in some cases, resell them at much higher prices. The not-so-fast customers go away empty-handed or have to pay higher prices on the secondary market. To prevent this, the Japanese government is banning speculation with protective masks from mid-March. Mask manufacturer Moldex, which currently produces in three shifts, is raging against the “usurious prices” on eBay. There, the masks, which cost €1.80 at Moldex, are offered for 25 to 30 euros. Is that fair?

On the other hand, what happens if the supplier raises prices in an emergency situation? The early customers only buy the amount they really need. The later customers also get their money’s worth. At the same time, the higher price sends a signal to the producer that it is worthwhile to produce larger quantities of the product quickly. The chance of higher profits creates a strong incentive to throw more into the market, therefor increasing supply. Consumers may have to pay more, which annoys them, but they get the product they need.

A similar situation concerns Uber’s surge pricing after a terrorist attack in Australia in 2014. The demand for Uber rides increased abruptly after the attack and, as a result, Uber’s software automatically increased prices. These higher prices attracted more Uber drivers to the place from which people wanted to flee. However, the media response was very negative. Uber was massively criticized for the price hikes. Similar incidents occurred in other cities as well. In the case of a terrorist attack in London, Uber reimbursed passengers who had paid the surcharge. Uber learned from this experience and now intervenes manually when demand increases suddenly and sharply.

Very innovative life-saving medicines present us with even more difficult ethical questions. Kymriah, a gene-based therapy from Novartis, cures a specific type of leukemia with a single injection. What is a fair price for such a product? In the US, an application costs up to $475,000. In Germany, the price is €320,000. The product Luxurna cures a genetic defect that leads to blindness in children. It is said to cost $850,000 in the USA, but a partial refund is offered if the recovery goals are not met. The most expensive drug in the world is Zolgensma, which was approved in the USA in 2019. It cures atrophy of the spinal muscles, a catastrophic condition that can affect babies, with a single injection. The price of about two million euros caused outrage. Novartis has offered to raffle off 100 therapies, which has also been controversially debated.

Are such prizes fair and ethically justifiable? I have no clear answer to this question. With this article, I just want to clarify that the question of price ethics in emergency situations, like the current corona crisis, is not as simple as it seems at first glance. Consumers have to decide for themselves whether they prefer to pay a higher price and actually receive the product they need, or whether they prefer constant pricing, creating a situation where many consumers are left empty-handed or have to pay higher prices on the secondary market.

Emergency Pricing against Corona: Think out of the box, but with caution

The Corona crisis is a demand crisis, not a cost crisis. It is therefore insufficient to make securing liquidity and cutting costs your top priorities. You must also utilize emergency pricing to combat declining sales.

The VW diesel scandal presents a textbook example. VW needs 2,000 orders per day in Germany to keep its plants running. After the diesel scandal became public in 2016/17, demand collapsed to less than 1000 daily orders. Catastrophe loomed for the factories. Until that point, VW had granted discounts of several hundred euros per car. Someone suggested introducing an “environmental bonus” of €5000, about ten times the previous discount (a “crazy” idea). After a quick assessment of sales and financial effects, however, the emergency action was implemented without delay. Within a short time, demand returned to required levels. The emergency measure cost a lot of money, but it saved factories and jobs.

This is an ideal example of an effective emergency measure. Sectors such as tourism, transport, hospitality, foodservice, trade fairs, etc., are already being threatened with demand breakdowns. Fast action is mandatory!

In these situations, price is the most effective instrument. Price reductions can be implemented within a few days and quickly result in a strong customer impact. However, it is critical to know the price elasticity. The price sales curve for large price changes is not linear – it has a kink. But where is this kink? Is it 10, 20, 30 or 50 percent? If you don’t know that, you are taking a big risk. A price reduction that is too small does not result in a significant sales increases – it only sacrifices the contribution margin. You have to go beyond the kink, but not too far beyond it. If you go too far down, sales volume may explode, but it will do so at the expense of the profit contribution margin. With high marginal costs this can lead to disastrous losses. Emergency pricing must be based on solid estimates of customer and market response. The effects on employment and profit must be carefully quantified. In some cases, price reductions do not lead to higher sales. For example, inner city car parks remain empty on Sundays despite a 50% discount on entry prices. In these cases, price reductions only destroy contribution margins.

An interesting effect of emergency pricing is the acquisition of new customer groups. This trend is often observed in the automotive industry, but also occurs in sectors such as tourism or hospitality. Extremely low prices attract customers who were previously unable to afford the product or service. This can result in loyal customer relationships.

An alternative to radical price reductions are rebates in kind. They bring several advantages in a crisis:

  • The nominal price level is maintained.
  • In terms of profit, they are more advantageous than price discounts of the same percentage.
  • They bring more volume and thus employment.

The Fullerton Hotel in Singapore has been offering such a discount in kind since March 10, 2020. Customers who pay for one night get a second night for free. In fact, all visitors who stay more than one night receive a reduced price for their total stay.

A manufacturer of designer furniture also recently created positive customer experiences with discounts in kind. This leading brand attaches great importance to price consistency and continuity. When customers demand a discount, which they do with great regularity and persistence during crisis situations, they are offered another piece of furniture as a free gift. In the vast majority of cases, this gift in kind removes the discount issue from the table. The result is both a positive employment effect (more goods are sold than with direct price discounts) and a higher contribution margin. The higher contribution margin is due to the fact that manufacturers and customers rate free gifts differently. The customer perceives a value equal to the purchase price and the manufacturer only has to bear the variable costs. The manufacturer gives a “present” that is worth 100 euros in the eyes of the customer but that only costs the manufacturer 60 euros. In the case of the direct price discount, on the other hand, the manufacturer has to renounce the same amount that is granted to the customer.

One last recommendation: In a crisis, you have to be quick, but you also must be cautious and diligent.

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