The Hidden Dangers - and Payoffs - of “Targeted Pricing”Published: March 26, 2003 in Knowledge@Wharton
Should your firm target your competitors’ customers with lower prices than the competition charges them? When might it make sense, instead, to offer discounts to your own customers? Under what conditions might this sort of approach – known as “targeted pricing” – backfire by driving everyone’s prices down too far?
Once widely hailed as a panacea, “targeted pricing” has also been condemned by many as a potential road to ruin. But is “targeted pricing” really either a panacea or a peril? Recent research by Wharton marketing professor Z. John Zhang and several colleagues examines the complex dimensions of “targeted pricing” and suggests that while this approach isn’t for everyone, it can be an effective tool under the right circumstances. Zhang and his colleagues also lay out guidelines to help companies understand when “targeted pricing” might play an effective role in their marketing strategy.
Capturing Money Left on the Table
Why has “targeted pricing” attracted so much attention among consumer marketers? According to Zhang, the reason is that targeted pricing allows firms to sidestep the inherent drawback of classical, uniform pricing. As Zhang noted during a recent presentation, “With uniform pricing, a firm always faces the tradeoff between ‘money left on the table’ and ‘foregone profit.’ [That is,] it has to go for either volume or margin, and therefore cannot capture all the value it has created in the market.”
Targeted pricing, in contrast, allows firms to “charge lower prices to new customers without giving discounts to those who do not need any inducement to purchase from the firm,” says Zhang. “Big firms with large market share really value the flexibility of targeted pricing because it allows them to act like niche companies. Who wouldn’t want the incremental sales?”
The good news is, targeted promotions are now possible because, as Greg Shaffer, a professor at the William E. Simon Graduate School of Business, and Zhang recently wrote in a paper entitled “Competitive One-to-One Solutions,” “consumers are individually addressable and firms know something about each customers’ preferences.” For the first time in history, marketers can easily collect an enormous amount of data about individual consumers, and mine that data quickly to understand preferences and buying behavior. They can automate a process of making “dynamic one-to-one” promotions that zero in on preferences, and change as customers’ needs are changing.
Why then has “targeted pricing” become so controversial? The bad news for marketers is that data-processing is a two-way street. Also for the first time in history, customers can easily collect an enormous amount of data about pricing offers of various companies with products or services that interest them. This extra layer of knowledge can lead to all sorts of changes in the way customers respond to promotions.
Zhang’s research probes the complex, unintended pitfalls of “targeted pricing” in the fast-moving Internet age. Using a combination of game theory and behavioral experiments, Zhang’s statistical analysis shows how and when “targeted pricing” can provoke strong feelings of “betrayal” and “jealousy” among loyal customers who feel left out of pricing promotions given to new customers. In those experiments, Zhang’s team designed behavioral scenarios of target-pricing scenarios and surveyed the responses of students to various possibilities.
The betrayal effect, Zhang writes, comes into play when “consumers prefer their favored firm less if it offers a promotion to switchers.” The jealousy effect, in contrast, is felt when “consumers prefer their favored firm less if another firm offers a price decrease to its own loyal customers.”
For example, Zhang’s research probes how loyal customers of Firm A would react if Firm A targeted “switchers” (new customers) with lower prices, and Firm B did not engage in any targeted pricing. Zhang’s conclusion: “When … both firms make use of targeted promotions in this market, the firms would be better off targeting their own [loyal] customers, instead of [targeting] switchers.”
A major, hidden danger of “targeted marketing,” continues Zhang, is that it’s easy to ignore (or under-appreciate) your own customers’ strong feelings of betrayal or jealousy. As Zhang writes, “If [both firms] ignore betrayal and jealousy effects, both firms perceive, incorrectly, that they can benefit more from targeting the rival’s customers [i.e., switchers]. This misperception causes both firms to employ the sub-optimal strategy of targeting switchers.”
In a paper entitled “Do We Care What Others Get? A Behaviorist Approach to Targeted Promotions,” written with colleagues Fred M. Feinberg and Aradhna Krishna, both professors at the University of Michigan Business School, Zhang goes on to list a wide range of potential missteps:
· An “excessive or inadequate degree of promotional activity”: Firms use targeted pricing when they should, or don’t use it when they should.
· “A bias toward targeting switchers”: Firms target switchers when they should not be targeting at all.
· “A tendency to under-target loyals”: Firms don’t target at all when they should be targeting loyals; and
· “Mis-targeting”: Firms target switchers when they should be targeting loyal customers instead.
Excessive targeting and mis-targeting can lead to destructive pricing wars, such as those that have helped to erode profit margins in the telecom and airlines sectors in recent years. Explains Zhang: “Pricing flexibility can be a problem when all the competitors are bidding for the same customers. In such a case, price competition intensifies and everyone is worse off.”
Zhang’s analysis helps explain the demise of so many online retailers who focused their marketing strategies on stealing customers from the competition rather than building loyalty among current customers.
Dot-coms such as Buy.com, which consistently charged lower prices than amazon.com, the major survivor among online retailers, suffered huge losses even as it acquired (and then lost) large numbers of new customers. Another sector where this analysis proves useful is the airline industry, where “prices are so flexible, there are [literally] thousands of different fares,” Zhang notes. “It’s a reason for the recent problems of the airlines.” In the past, he adds, “people thought that if you do targeted pricing, you always want to use discounts to attract the competition’s competitors. But that is not necessarily true, because it can lead to churn.”
When Targeted Pricing Makes Sense
Rather than dismiss targeted marketing out of hand, however, Zhang’s research found “some companies can be better off as a result of targeted pricing.” Offering lower prices to switchers, Zhang writes, “may be sustainable in certain industries.” He cites the following conditions: “where information flow tends to be slow; where there are barriers to the free exchange of information …; where consumers believe it is not in their interest to actively take note … or where firms can explain price differences for motives other than profit gain.”
Strong branding and a reputation for high quality can also protect companies from the betrayal and jealousy effects. “Companies that have high-quality products and lots of loyal customers can be better off as a result of targeted pricing,” Zhang says. After all, loyal customers are less likely to suffer betrayal or jealousy when the competition can’t offer them the same “value proposition.” Companies with strong brands, such as Sony, can charge higher prices than the competition, even when those prices are readily accessible on the Internet, Zhang adds.
Zhang believes that, for all its pitfalls, targeted “one-to-one” pricing can effectively be used, in some circumstances, to target other companies’ customers. A major key is to “offer something to everyone, including your current customers. It’s a question of framing the deal.” To illustrate that point, Zhang cites the public relations nightmare amazon.com suffered when some customers discovered that the company was offering lower book prices to “switchers” (new customers) but not to loyal customers. “Television picked up this story, and it was a huge problem,” recalls Zhang.
But this doesn’t prove that “targeted pricing” of competitors’ customers is an intrinsically flawed proposition, he says. The problem was not with the concept of targeted pricing, but with the way in which amazon.com implemented it. Amazon’s mistake was that it gave something to “switchers” (new customers), but nothing to its loyal customers. “Everyone should get something. Amazon could have given, say, a 20% discount to loyal customers, and a 40% discount to new ones. You have to frame the deal properly.”
Current customers don’t necessarily have to be offered discounts, adds Zhang. To avoid the betrayal and jealousy effects, marketers could offer loyal buyers a range of unique value-added services and special features. “You have to be sensitive to consumers. They may be able to join a club with other advantages, or get free shipping or gift wrapping,” as amazon.com has been offering.
One consumer sector where targeted pricing is proving especially effective is financial services, says Zhang. Leading institutions, such as Wells Fargo and MBNA, target competitors’ customers not only with lower interest rates but a host of “one-to-one” services. These institutions use data mining tools to collect detailed information about competitors’ customers and offer them “thousands of different products” tailored to specific needs, notes Zhang. “They put all the information about a person together and create a more detailed assessment of risk. Then, they offer a lower interest rate [and other services] to acquire the loyalty of new customers.”
Properly managed, this sort of approach can improve the profit margins of financial institutions even as it drives down the average interest rate in their loan portfolios. That’s because, as Zhang explains, “targeting pricing” enables financial institutions to focus on finding – and retaining – low risk customers. “In a theoretical situation where you have no financial information about customers, you have to offer everyone an average interest rate. Your competition knows the low-risk guy is paying too much, and the high risk guy is paying too little. Now, you can give the lower rate to the low-risk guy, and he won’t leave you. You can also give the higher rate to the high-risk person, and if he leaves you, you don’t care.”
On the contrary, Zhang asserts, when a high-risk customer jumps ship for a competing bank, the customer becomes your competitor’s problem, not your problem. Meanwhile, you have locked in a low-risk customer with “one-to-one” pricing and services.
Guidelines for Offensive, Defensive Promotions
Rather than shun “targeted pricing” as always too risky, Zhang sees this approach as a potentially useful tool for eliminating “customer churn.” As Zhang and Shaffer write, “Instead of trying to minimize [churn], the optimal way to manage customer churn is to engage in both offensive and defensive promotions with the relative mix depending on the marginal cost of targeting.”
How do you calculate a mix that makes sense for you? A good place to start is to study what your competitors are doing. “When you make decisions about targeted pricing,” says Zhang, “you must be sensitive to the fact that the competition is doing this, too.”
Firms should also take a long hard look at how much information about pricing options is available to their customers. “In markets like telecom, everyone has the same information” about various companies’ pricing, and everyone is “a little more offensive,” notes Zhang. In other markets, however, information may be less easily available, and old customers are less likely to feel jealousy and betrayal if you leave them out of new promotions.
Another consideration is to achieve a balance between aggressive and defensive promotions. “Even if you are aggressive in targeted pricing of other companies’ customers, you have to [also] shore up your own customers with loyalty programs and other benefits.” Zhang notes. Companies that enjoy a large market share should “be a little more defensive” in their mix of promotions than companies that are more concerned about acquiring new customers and boosting market share.
In any case, marketers have to remain flexible, and responsive to the changing needs of their customers. “Many businesses have trouble measuring or justifying the impact of their customer relationship management [CRM] efforts,” says Zhang. “But ‘targeted pricing’ can have a very tangible benefit, allowing you to do CRM more effectively.”