Price Gouging = Capitalism?

If it takes three incidents to confirm a trend, the pharmaceutical industry is most certainly immersed in a trend.

And what is that trend? MyLan CEO Heather Bresch would call it capitalism. When asked why she increased the price of the severe allergy treatment EpiPen from $100 to $600 per unit, she responded “I am running a business. I am a for-profit business. I am not hiding from that.

Let’s paraphrase her sentiment. In essence, Ms. Bresch justified her decision to sextuple drug prices on sick consumers who desperately need her product with the assertion: “That’s capitalism.”

And in the pharmaceutical industry, she isn’t alone. Recently, Turing increased the price of its anti-parasite medication Daraprim from $13.50 to $750.00 a pill. And Valeant Pharmaceuticals more than quadrupled the price of its blood pressure medication Nitropress after it purchased the drug from a rival firm.

That’s capitalism, eh? Apparently, the business executives of these organizations do not believe that they are running afoul of any price gouging laws or regulations by increasing their prices in this manner. Nevertheless, it remains to be seen whether any of these firms can sustain such brutal business strategies over the long run.

After all, it’s difficult to name any organization that has prospered over the long term by increasing sales prices to unaffordable levels while alienating desperate users. That’s why, for instance, Uber voluntarily capped its “surge prices” in Washington DC when the Metrorail public commuter service shut down for emergency repairs.

And Uber went much further than establishing a simple price cap. It announced: “We will work around the clock to keep DC moving tomorrow. We are extending uberPool to the entire metropolitan area during the closures to maximize every car on the road while also keeping prices down for riders. Passengers using uberX to travel with neighbors or co-workers can use the Fare Split option to share the cost of their trip.”

Did Uber’s executives voluntarily take such steps out of an altruistic desire to help their customers? That is one possible explanation. Another explanation, though, is that Uber’s executives may have feared a public backlash over any price gouging activities. That is a very rational concern, and Uber’s executives undoubtedly made a very sound business decision.

In light of that decision, the behavior of Ms. Bresch and her colleagues may strike us as being extremely short sighted. Although price gouging may be legal and profitable in the near term, it cannot help but compel customers to despise their suppliers in the long term.

And no for-profit business can possibly prosper for long when surrounded by stakeholders who hate it. That’s why global banking organizations like Goldman Sachs are dedicating significant resources to public relations initiatives that are restoring their brand reputations after their financial crisis collapses.

To be sure, price gouging firms like MyLan, Turing, and Valeant are undoubtedly for-profit capitalist businesses. But more consumer friendly firms like Uber and Goldman are capitalist businesses too, and they will likely earn more profits than their price gouging pharmaceutical colleagues over the long run.

The Auto Industry’s Ethics Problem

Automobile sales have been surging in the United States lately, driving up consumer spending and boosting the national economy. If you are one of the Americans who need a new car, which model will you choose?

A European model? Perhaps not. Volkswagen, the German manufacturer that is now the largest auto maker in the world, recently admitted to a mind boggling fraud. While promoting millions of vehicles as environmentally Clean Diesel devices, VW intentionally built the cars with technology that tricked pollution testing equipment into giving the engines passing grades.

In other words, they promoted the cars to environmentally conscious consumers as green vehicles. But the autos actually spewed illegal toxic fumes into the atmosphere, and were rigged to cheat on the engine tests that are periodically required in the United States.

Well, then, will you select an Asian model instead? Once again, perhaps not. Toyota, the largest of the Asian automobile manufacturers, was recently forced to recall millions of vehicles because of devastating car accidents involving unintentional acceleration. In a wide variety of situations, drivers found themselves behind the wheel, trying desperately to stop automobiles that were accelerating out of control.

What about other Asian models? Hyundai / Kia, the largest Korean manufacturer, wouldn’t offer you much of an alternative. Just last year, the American government fined them for brazenly lying about the fuel mileage of their automobile models. Unlike Volkswagen, the firm didn’t instruct their engineers to develop clever technologies to trick regulatory testing devices into certifying the performance claims of their vehicles. Instead, they simply lied about their performance.

Then how about selecting an American model? Yet again, perhaps not. General Motors, the largest manufacturer of America’s Big Three, is still managing the fall-out of its ignition switch scandal. For many years, its engineers knowingly allowed one hundred customers to die because of a mechanical defect that it illegally hid from the government and the public.

So what is going here? Why is the entire automobile industry led by manufacturers that behave in this way? Perhaps the root cause of the problem is the nature of the firms’ sales distribution networks. By relying on networks of independent dealers to sell their products, the firms are insulated from their own customers and thus fail to be influenced by their concerns.

Such insulation problems are not unique to the automobile industry. Steve Ballmer, the long time chief executive of Microsoft, has spoken about the company’s decision to design, produce, and sell Surface tablets directly to the public without contracting with its Original Equipment Manufacturers (OEMs) and distribution partners. According to an interviewer of Ballmer:

“As expected, Microsoft’s OEMs, some of whom said publicly they felt blind-sided by Microsoft’s decision to make its own devices, were none too happy about the move. But Ballmer insisted Microsoft had no choice.

‘I was concerned that we had areas of vulnerability in competing with Apple and without any (first-party) capability, that we were not transacting that well just through our OEM partners.”… our OEMs were having a hard time investing in competing with the higher end brand. The (Microsoft retail) stores … hadn’t taken off … that was also an issue … our OEMs do great work, but there are places their brands and investments don’t travel.’”

Nevertheless, Microsoft’s products don’t kill their customers, as do the products of automobile manufacturers. And Microsoft has not been accused of lying about the performance of its products to the government and the public. So what unique feature of the automobile industry’s sales distribution strategy is promoting such ethical lapses?

Although it’s impossible to pinpoint a single causal feature, one contributing factor might be the manner in which sales prices are established with individual buyers. After all, how many customers are truly prepared to engage in complex haggling with auto dealers — i.e. with professionally trained negotiators — to agree on prices?

Most customers know that they are not equipped to do so. And as a result, many feel uncomfortable about the process of purchasing an automobile.

Does this culture of “haggling vigorously with your own customers for every penny of every sale” itself promote unethical behavior? The only way for a manufacturer to know for sure would be to experiment with haggle-free policies, and to observe whether such practices align their cultures with the interests of their own customers.

Until a manufacturer decides to try that approach, good luck! And let’s be careful out there.

The Met and MOMA: Nonprofit Luxuries?

Seven years ago, in 2004, New York City’s Museum of Modern Art generated headlines by becoming the first major art museum in the United States to establish a standard admission fee of $20.

$20? For a nonprofit organization that claimed — and still claims — to be “accessible to a public that ranges from scholars to young children”? At the time, many critics believed that the charge was a bit steep.

Nevertheless, the year 2004 was a time of economic growth and prosperity in the United States. Perhaps the executive team at MOMA believed that, at a time of low unemployment, $20 represented a reasonable and affordable charge for access to world-class cultural exhibits.

Our current recessionary climate, though, appears to represent a different economic environment … and yet the guardians of our cultural heritage are once again increasing their prices! Just last week, for instance, the Metropolitan Museum of Art in New York announced that it would be lifting its standard admission charge on July 1st from $20 to $25.

Broadway? The Yankees?

The Met, somewhat predictably, explained its decision to institute a $25 ticket price by noting various daunting budgetary challenges, including lower rates of donations and reduced levels of government support payments. The weak economy has likely damaged other sources of cash flow as well, such as the Met’s lavishly extravagant on-site facility rental and catering businesses.

$25 tickets? A catering business? Although the Met and MOMA both help support the Big Apple’s global reputation as a center of world culture, such characteristics are more commonly found at for-profit businesses than at nonprofit institutions. After all, New York’s Broadway theaters and its champion New York Yankees baseball club also serve food and produce entertainment events while charging high ticket prices, and yet they do not enjoy the benefits of nonprofit status.

All of these institutions produce high quality cultural experiences that enrich their local and global communities. And all are well known to their global audiences as world-class icons of the United States in general, and of New York City in particular. For that reason, all of these organizations receive some level of financial and operational support from local government sources. But if they all share these common characteristics, why are museums — but not theaters or baseball clubs — permitted to classify themselves as nonprofit organizations?

Nonprofit? Tax Exempt?

According to the Internal Revenue Service (IRS), tax exempt organizations must dedicate themselves to charitable, religious, educational, scientific, literary, or similar endeavors. Among other additional requirements, they cannot distribute their earnings to private shareholders or individuals, and cannot attempt to influence political legislation or elections. Instead, they must reinvest any net proceeds into these same charitable endeavors, and must remain completely apolitical at all times.

Interestingly, although all of the fifty states of the United States maintain their own nonprofit requirements, they do not necessarily need to synchronize their laws and regulations with those of the IRS. Thus, one can always find organizations that are registered as nonprofit entities at the state level, but that nevertheless pay income taxes to the federal government and other entities. In fact, some local taxation authorities skirt the IRS’s tax exempt regulations by mandating and collecting Payments In Lieu Of Taxes (PILOTs) from such charitable organizations.

The New York Yankees baseball team, as well as many Broadway show organizations, are controlled by owners that benefit financially from the earnings of these organizations; thus, these institutions cannot be classified as nonprofit or tax exempt in nature. The Met and MOMA, though, do not repatriate their earnings to owners and thus can legally exploit the benefits of nonprofit, tax exempt status.

Hybrid Entities

The clarity of this distinction is surprisingly sharp, isn’t it? Basically, even though museums may charge high ticket prices, their profits are plowed back into charitable purposes and do not enrich any organizational owners. Thus, unlike civic-minded family businesses like those of the Shuberts and even the Steinbrenners, the museums are not required to pay income taxes on their earnings from ticket revenues.

Nevertheless, hybrid entities are now emerging in forms that obfuscate the distinctions between nonprofit and for-profit organizations. Socially responsible investors and companies, for instance, dedicate themselves to serving the public interest even though they maintain for-profit, privately owned firms and pay corporate income taxes. Conversely, even the Smithsonian Institution in Washington D.C. — a museum that declines to charge any ticket prices — operates restaurants, gift shops, and publishing houses in order to raise funds to support its charitable activities.

So the next time you find yourself paying more for a set of museum tickets than you do for a decent dinner, please don’t complain that the institution is engaging in profit-gouging! As long as it adheres to the requirements of its nonprofit, tax exempt status, no private individual or organization will prosper from your ticket revenues, except for the museum itself and the public whom it serves.

Continental Airlines: No More Free Lunch!

Last fall, in an MSNBC interview about health insurance, Louisiana Senator Mary Landrieu employed a bit of sarcasm to criticize the hotly debated “public option” as “free health care … (that) everybody … doesn’t have to pay for.” She then declared, with an extremely firm sense of moral conviction, “there is no free lunch.”

Although the subsequent inclusion of a $100 million Louisiana Medicaid subsidy appeared to convince Landrieu to support the Democratic health care initiative after all, she never retracted her statement that “there is no free lunch.” And this past week, Continental Airlines helped her prove her point by discontinuing complimentary meals on all economy class trips.

Let Them Eat Pretzels!

Until a few days ago, Continental remained the last major airline in the United States to offer free meals to passengers with coach class tickets. That’s not to say that their meals were extravagant; each breakfast consisted of a muffin or box of cereal, and each lunch contained a single small sandwich.

Nevertheless, Continental had insisted on serving complimentary meals to domestic economy passengers for many years, just as Southwest Airlines had insisted – and continues to stand alone in insisting – that two pieces of checked luggage should be provided on a complimentary basis. Although Continental is now assuring us that pretzels and soft drinks will remain free of charge, they aren’t ruling out the adoption of other nuisance fees, such as the pillow and blanket fees imposed by American Airlines.

But why did the airline industry adopt this pricing strategy? When is it reasonable to charge premium fees for every convenience, real or imagined, that customers request?

May I Take Your Order, Please?

For many years, airline analysts have described the airlines’ fee policies in terms of an a la carte menu, similar to the pricing policies utilized by many restaurants. Defenders of such policies explain that restaurant patrons seldom expect to receive free bottles of wine with every meal, or free slices of apple pie with every cup of coffee.  So why should airline passengers expect free blankets and pillows on every flight?

Critics of a la carte airline pricing, though, retort that restaurants hardly ever impose convenience fees to serve tap water; nor do they apply premium charges for coat check services. And yet they do charge customers for minor services like valet parking, as well as for small dishes like lettuce garden salads.

So how do businesses determine their pricing strategies? How do they choose between an a la carte menu plan and a prix fixe plan? An appropriate decision can obviously enhance revenues, but a poorly implemented one can infuriate a customer base.

You’ve Got a Problem

An effective pricing strategy is not solely the product of computational economic analysis; it is also a function of the qualitative management of customer expectations. And expectations management, in turn, requires a basic understanding of human behavior.

To put it simply, people don’t enjoy feeling fooled, and they don’t enjoy feeling cheated. So businesses should always take the time to inform customers precisely how fees are calculated; any other approach would incur the risk of leaving customers feeling fooled. Furthermore, fees should always be established at levels that are reasonable in comparison to the ostensible costs of providing each service; any other approach would incur the risk of leaving customers feeling cheated.

Thus, restaurants are comfortable charging for side salads because their customers understand that they obviously need to spend resources on salad ingredients; likewise, they charge for valet parking because they clearly need to procure space to park the automobiles. As long as their charges are reasonably disclosed and appropriately priced in relation to the underlying costs of the corresponding services, customers seldom squawk about paying such fees.

But the costs of placing the coats of restaurant patrons on hangers are obviously minimal, and thus customers would inevitably feel cheated if surprised with fees for such services. And airline charges for blankets, pillows, and tiny snacks inevitably leave passengers feeling cheated as well. As the president of the US Airways chapter of the Association of Flight Attendants explained when that airline stopped charging for soft drinks, “(we’re) a customer service industry, and if you’re not pleasing your customers, then you’ve got a problem.” Obviously, customers cannot feel pleased when they feel they’re being cheated!

Step by Step, Slowly I Turned …

So what is an airline to do if it wishes to implement an a la carte pricing policy? To paraphrase the comedy team of Abbott and Costello, an effective strategy might involve moving step by step, slowly but surely, to begin shifting customer expectations, and then to wait for other airlines to follow along.

It takes time for customers of any business to become accustomed to new pricing strategies. A gradual, evolutionary approach is thus best suited to reposition any new pricing policy — or any other customer service policy, for that matter — as an acceptable rule instead of as an unusual departure from established norms.

In reality, airline passengers were conditioned by years of watching their free lunches shrink from multi-course affairs to meager shrink wrapped snacks. Eventually, these meals shrunk to such miniscule proportions that when they disappeared entirely, most passengers hardly noticed at all.

Replacement Value: Be A Comparison Shopper!

Less than two years ago, the literary world cheered when Amazon released the Kindle, its original lightweight electronic book reader. Finally, the e-book would replace the printed word!

Then they took one look at the retail price and stopped cheering. $399? That was more than 10 times the price of a new hardcover bestseller! Would any one actually spend that amount of money on a book display gadget?

A year later, the world plummeted into a Great Recession; gross domestic product collapsed and unemployment soared. So what did Amazon do this past week? They introduced a deluxe version of the Kindle … and raised its price to $489!

Hello, Pace University!

Once again, critics gasped and squawked. $489? Would any one pay $489 for a device that simply displays images of book, newspaper, and magazine pages?

Before we assume that Amazon CEO Jeff Bezos has lost his mind, though, let’s ask ourselves a few brief questions. Where did Bezos announce this new product? Why did he select that location? Who is his target audience? And – here’s the big question – if his target audience decides to pay $489 for a deluxe Kindle, what will the device replace when they use it?

Let’s start with the answer to our first question: Bezos launched the product at Pace University in New York City. Why? Because the new Kindle has a large screen and can display e-textbooks easily.

Yet it can display e-newspapers and e-magazines easily as well. So why not launch it at the New York Public Library? Or in the New York Times building? Or at Conde Nast? Why target students and not other readers?

It’s the Replacement Value, Stupid!

Sure, the new deluxe Kindle can display newspapers, but how much money are newspaper readers paying for their product? Well, if they’re reading the online version of the New York Times, they’re not spending a penny. And even if they pay full price at a newsstand, beginning next month, they’ll only spend $2 per copy. So the cost of a deluxe $489 Kindle is over 200 times the cost of a newstand copy of the Times, and infinitely larger than the cost of free online access.

But what about university students? The deluxe Kindle is designed to provide them with electronic products that can replace their textbooks. At the present time, they spend almost $200 on each book, plus the cost of study guides, sales taxes, and other assorted fees and expenses.

So, let’s think about these costs in terms of replacement value. The cost of an original Kindle was more than 10 times the cost of each hardcover book that it was designed to replace. And the cost of the new Kindle is more than 200 times the cost of each newspaper that it is designed to replace. However, the new Kindle is merely 2 to 3 times the cost of each textbook that it is designed to replace.

That makes the new deluxe product a bargain purchase at $489. After all, for college students who are required to purchase 4 or 5 textbooks each semester, it pays for itself after a single trip to the bookstore. That’s why Amazon is targeting students, and that’s why Bezos made his announcement at Pace University a few days ago.

Choosing A Replacement Target

Sometimes success is simply a matter of choosing a replacement target wisely. For instance, are you a coffee lover? Then perhaps you should consider McDonald’s recent success with your favorite beverage.

Until recently, coffee was simply another item on the menu; then McDonald’s began to position it as a replacement for Starbucks’ brew. They renamed it McCafe, and posted billboards that declared that Four Bucks Is Dumb for a simple cup of java. Suddenly, after being positioned as a replacement for a Starbucks product, McCafe soared in popularity.

That’s a good example of product positioning; now would you care for a bad one? Then consider the luxury box seats at the new Yankee Stadium, the most expensive of which were originally priced at $2,500. Why would any one pay that much money for a ticket to a ball game? Well, the Yankee brass positioned their product to be far more than a game; their fans were buying into unique dining options as well, served in luxury suites with teak arm chairs, personal concierge service, and a private entrance, elevator and concourse.

Unsurprisingly, there was scarce demand for this product, and the Yankees were forced to slash their prices by 50%. Why was there so little demand? Well, the team decided to position their product as a luxurious night on the town instead of a simple night at a ball game. That placed them in direct competition with a Broadway theatrical experience. And even though a steak dinner in Manhattan now costs $300, Broadway orchestra seats now cost $200, and post-theater drinks now cost $100, a luxurious night in the Bronx under the Yankees’ original pricing strategy cost more than 4 times a replacement night under the great white lights of Broadway.

So in the spirit of the Great White Way, to predict whether your show will be a hit or a flop, try thinking like a comparison shopper. Is your product’s price superior to its replacement value? If your customers are going to evaluate your pricing strategy in these terms, you should obviously do the same!