“Tactical pricing assumes that price sensitivity is a constant

The Strategy and Tactics of Pricing Sixth Edition (page 148)

Thomas T. Nagle and Georg Müller

Many companies have seen dramatic changes to demand structure over the past three months.

Surveys and interviews suggest that people are beginning to look beyond the immediate response to the pandemic to adapting to the new normal. This is part of the normal cycle of resilience - efficiency - adaptation. Those companies that were resilient enough (or lucky enough) to pass through Covid 19 are now asking how they adapt to the new normal.

But what will the new normal be? Things are not yet settled. There is a way to make sense of alternate futures. It is the well documented process of scenario planning.

Fortunately, there is a strategic discipline called scenario planning that is designed precisely to address this kind of uncertainty. Scenario planning takes for granted that it is hard for human beings to imagine the future as being radically different from the present. As a result, its practitioners don’t try to predict what will happen, but to stretch the mind to think about what might happen. Peter Schwartz, one of the originators of the technique, wrote in the introduction to his book about it, The Art of the Long View, the scenario is “a vehicle . . . for an imaginative leap into the future.”

This quote is from the excellent article by Tim O’Reilly, publisher of O;Reilly books, “Welcome to the 21st Century: How To Plan For The Post-Covid Future.”

How can we apply scenario planning to pricing?

There is a hint in the quote from Nagle and Müller. Begin by looking at price sensitivity. Breaking this down, we are actually interested in price elasticity of demand (how demand changes in response to price) and cross price elasticity (how likely a buyer is to change vendors in response to a price change). These are often seen to be stable and in normal times they are. The best practice is to segment your market by these two types of elasticity.

In today’s market, these relationships are changing. The first responsibility of product and market leadership is to understand these changes and prepare for them.

Segment your current customer base by price elasticity of demand and cross price elasticity.

You don’t need to (and are probably unable to) do this quantitatively so make do with the gut feel of your sales force. Ask them to put customers and prospects into three buckets:

• We could increase prices by 10% and it would have little impact on volume

• Neutral

• We could reduce prices by 10% and it would increase volume

Then ask the same question about what customers and prospects would do relative to competitors:

• If we increased prices by 10% would the customer or prospect stay with us or go to a competitor

• Neutral

• If we decreased prices by 10% would prospects switch to us or stay with our competitor

This is NOT a pricing exercise and is not meant to in form pricing decisions. That would require a lot more analysis. It is a shortcut to segmenting your customers by market dynamics.

Once you have done this, ask two questions:

1. Was this different in February 2020?

2. Will it be different in February 2021 if

   1. The Covid 19 pandemic is over

   2. There is a second wave for Covid 19

This simple exercise will give you the information you need to begin building a scenario planning based pricing strategy. You will need a plan for customers that have moved from one quadrant to another as they will start behaving differently.

Let’s give a concrete example.

A customer that was in a commodity market (high cross price elasticity and high price elasticity of demand), but that now has low price elasticity of demand requires a new pricing strategy. This could happen because the customer’s own business now has lower price elasticity of demand itself. Companies supplying the travel sector or entertainment sector are examples. Demand is greatly reduced and prices could be cut by 90%. without having much impact on overall demand.

In a commodity market, the pricing strategy is basically to follow the market price. In a market with high cross price elasticity (buyers switch vendors easily) but low price elasticity of demand (volume does not respond to price levels) it is easy to trigger a price war and a more balanced and long-term pricing strategy is required. The market dynamics here resemble the game of Prisoner’s Dilemma.

In Prisoner’s Dilemma, one has to choose whether to confess in the hope of a lighter sentence or remain silent and hope the other prisoner will also remain silent, in which case neither party goes to jail. The best strategy differs greatly depending if you are playing just once or if the game is open ended, and will be played again and again. In most markets, pricing is a series of ongoing moves and you have to look out into the future.

Prisoner’s Dilemma was studied extensively by Robert Axelrod in two classic books, The Evolution of Cooperation and The Complexity of Cooperation. Axelrod invited people to submit software programs that would play against each other to see which would win over multiple rounds. You can actually explore this on this website where you can compete yourself or run different strategies against each other. The short version is that the most successful strategy was Tit for Tat with forgiveness. Start by ignoring the competitor’s price change, and then do whatever the competitor did the previous time, while ignoring competitor price cuts from time to time (that is the forgiveness part).

We go into this in much more detail in The jobs of pricing scenarios.

Willingness to pay is another critical consideration in building up a scenario planning approach to pricing strategy.

Willingness to Pay or WTP is used by some pricing consultants as a proxy for value. This is a bad approach as willingness to pay is not a given but a dynamic outcome of how you deliver value relative to your competitors. See What Shapes Willingness to Pay. Because willingness to pay is dynamic, and can change when business conditions change, it has to be considered in your pricing scenarios.

A quick way to do this, one that does not require expensive consultants or a lengthy process, but that can still give insights, is to ask how customers and prospects get value and how this may have changed.

For each customer ask

1. Has how this customer creates value for its customers changed?

   1. Are they creating more value?

   2. Are they creating less value?

2. Has how we create value for this customer changed?

   1. Are we creating more value?

   2. Are we creating less value?

Ask the same question about the situation in February 2020 and what the situation might be in February 2021.

Even these simple ways of generating pricing scenarios will help you to exit the Covid 19 pandemic and be prepared to take the steps you need to deliver enhanced value and thereby drive up willingness to pay.

This agile pricing scenario process has the following steps.

1. Set up three time points to consider, before Covid 19, the present, a time when the Pandemic has become factored in to the general economic situation (we suggest February 2021 above).

2. Segment your customers using changes to cross-price elasticity and price elasticity of demand for these three time frames and look to see if any customers change segment

3. Segment your customers using changes to how much value they are creating for their customers and how much value you are creating for them. Again, do this for these three time frames and look for the customers that change segments.

4. Combine the two approaches to segmentation and look for deeper patterns. The simplest way to do this is to look for companies that change segment under both lenses. Focus on the pricing strategies that you will create for these companies.

The key thing is to recognize what has changed and to understand that it is probable that your old segmentation and expectations about customer behavior may have changed dramatically. Your pricing strategy has to change accordingly.

“Most that people, including managers, make are made from habit. When the decision turns out to be the right one in most cases, it gets applied without thinking. When changes occur or when a new market involves forces that do not fit the patterns of one’s experience, it is important to recognize that traditional strategies need to be rethought.”

Thomas T. Nagle and Georg Müller