Price Sensitivity and Opportunity Cost

It's occurred to me that conversations and decisions on the topic of price sensitivity tend to neglect the notion of opportunity cost, and particularly in times of economic hardship, it is likely more influential to buyer behavior than it normally is ... though given that the present financial downturn has persisted for at least five years, we may need to revise our perception of "normal," as the lessons learned during the present slump and the behaviors to which consumers have become habituated will likely persist even after the storm has passed.

Cost of Production

The cost of production is relatively straightforward: the producer considers their variable costs, overhead, cost of capital, and required return in providing a good to the market, and the very least the customer can expect to pay is a price that covers those costs, which for some is the basis of their consideration of a fair price.

However, costs of production are very rarely considered by the customer, who are primarily concerned with their own needs rather than the needs of the producer.   It is especially rare in cultures that do not engage in haggling, but have the expectation that the price as marked is not negotiable.  For the majority of purchases in US markets, that is the case: we do not haggle with the grocer over the price of a melon, as is common in some eastern cultures, but take it or leave it based on the demanded price.

As an aside, I'm often surprised by the number of people who do not seem to recognize when haggling is appropriate.   People seem to take the price of items such as furniture or jewelry to be non-negotiable, and the only realm in which they feel haggling is possible is in the automotive sector or private sales.  Of course, there is another species of customer who seems to feel haggling is appropriate in venues where it is not, much to the chagrin of others who are waiting to be served while they waste time hectoring store clerks for a better deal.

And of course, all of this is a diversion, the point being that production costs are an indirect influence on the customer's assessment.

Need-Based Cost

Another common approach to evaluating prices is in the customers' assessment of their needs: whether worth the cost to satisfy a need, or whether the consequences of failing to fulfill the need necessitate paying the cost. It is essentially a binary decision - to buy or not to buy in a specific instance, not yet considering alternative methods for suiting a need (see next section).

It stands to note that vendors cannot accurately assess the needs of a customer and how much it is worth to have those needs fulfilled.   The customer knows these things with certainty, and the vendor can only guess.  They very often guess wrong, covetous of profit per sale and indifferent to sales volume.

Need-based pricing is a common consideration when a vendor that assumes the customer will not purchase in future if he does not do so immediately.   It's also a negotiation tactic used to place artificial pressure on the buyer to create the impression of a now-or-never (or "limited time only") deal when such is not the case.   When it works it can result in a good profit on a one-time sale, but when it fails it fails disastrously and devastates the potential lifetime value.  And from the consumer's standpoint, it can be quite amusing to see how a vendor who has pulled that trick squirms when you fail to react.

But again, I digress: needs-based considerations are generally a preliminary decision (the customer would not be in the market at all if his needs were inadequate to the price) under normal circumstances - and that it only takes precedence in the customer's assessment in certain instances by dismissing all other bases.

Alternative-Based Costs

Alternative-based costs derive from needs-based costs: in this instance the customer recognizes that the cost of neglecting the need is unacceptable, but is considering cost in a comparative versus binary manner: there are other alternative that can be chose to address the need, and the customer assesses whether one possible option is the most efficient use of his budget.

This may be a product-based decision (a customer needs to clean a floor but is choosing between a vacuum cleaner and a broom) or a brand-based decision (a customer has tentatively chosen a vacuum cleaner and is now choosing between a Hoover and an Oreck).  The binary test of whether the item is adequate to solve the problem has been satisfied, and the customer is considering more qualitative factors (how effective, how easy to use, etc.) in considering an option, mindful of his other options.

It seems to me that the alternative-based approach is grossly overemphasized by sellers, as evidenced by marketing messages and promotional tactics that present comparisons to similar brands and products.  That's not to say it's invalid, nor to say that buyers do not similarly overemphasize alternative-based criteria, but ultimately the price that a buyer is willing to pay is based on the fulfillment of need, and they can be very intelligent and diligent in identifying other options, outside of what a firm considers to be its competition.

However, success at alternative-based appeals relies on the premise that the customer is able to afford an array of equally satisfactory options.   Which is to say that it functions well under "normal" market conditions, but falters in times of financial hardship.

Opportunity Cost

The topic of opportunity cost is often pointedly ignored in discussions of price sensitivity, largely because it is very difficult to focus in a meaningful way.   It pertains less to the purchase of an item in question and more to the entire budget of a customer and a holistic consideration of needs.  That is to say that it asks the question "Would I rather have this product, or would I prefer to have something else I might obtain for the same amount of money?"

That "something else" opens up a universe of possibilities that cannot be conveniently discussed or considered - but is again fundamentally derived from the needs-based decision by broadening the consideration.  Whereas alternative-based cost considers other products that might be obtained to service a need, opportunity cost considers other needs that might be satisfied with a budget.  In times of hardship, opportunity costs tend to take precedence in buying decisions.  Lacking sufficient budget to fulfill their every desire, the customer is not choosing between products but between needs.

Most vendors are loath to consider opportunity costs.  For vendors of luxury goods, making a prospect aware of more pressing needs is a losing proposition.  But even when the product in question is a necessity, it is culturally inappropriate to intrude on another person's financial affairs.   It would be highly inappropriate for a salesman to ask a customer the questions necessary to demonstrate that if he drank one less cup of coffee a day and switched to a cheaper brand, that would enable him to afford a car payment that's $25/month higher.  Not to say that some won't try, but it's taking a risk of offending a potential customer.

Even so, it seems that opportunity costs are a significant factor in the customer's perspective on price in times of economic hardship, and there may be instances in which it is less offensive and even welcomed for a vendor to encroach on that territory.  Taking the same example, a customer who is negotiating an auto loan with a banker expects to be asked, in a general way, what their "other expenses" are each month, and may even be tolerant of a bit of intrusiveness if the banker might help them discover ways to be able to afford a higher loan.  However, this seems unusual: the perception of the consumer is that banker has less at stake in the decision, is in a position of greater power, and is providing a supporting service rather than selling a product.

To end with a digression, as it seems that's the way things are going, the customer perception of banking is entirely wrong: the banker's profit from the loan is at stake, he is not in a position of power given that there are other sources of a loan, and he is in fact selling a loan product.  Most people don't seem to recognize that, and assume an overly docile negotiating position, to their own detriment, when dealing with certain vendors.

Convergence and Conflict

The main thrust of this meditation is to propose that opportunity cost is woefully neglected in the present market - but I've also sensed that, aside of the obvious diversions, I'm touching on yet a different concept: that of the convergence and conflict among these various perspectives on pricing.

Arguments of whether a given product is worth the price are common.  Not only is it implicit in the setting and negotiation of prices, but it's also implicit in any product review, and often surfaces in casual discussions about products and brands.   The source of disagreement may be in whether a price is justified among two people who share the same perspective but it is also common, and perhaps even more common, in discussions or negotiations between people who are taking different perspectives.

That is, one person may conclude a product is worth its price based on production cost criteria, another may conclude it is not based on needs-based criteria, a third may feel it's a good deal based on a consideration of alternatives, and a fourth may disagree because he is considering opportunity costs.

As such, in negotiation and agreement, it's likely necessary to identify the perspective before debating the criteria that underlie a conclusion - or when the debate is entirely internal, to the mind of a buyer faced with a purchasing decision, to be more deliberate in considering the various perspectives.