Hello Reader,

Frances Cook recently shared that the Reserve Bank found that firms are setting prices based not on costs or competitive activity, but on what the market will bear. As a consumer marketer, this obviously piqued my curiosity, so I've been digging into the Reserve Bank's docs on this. It's possibly not as pronounced as the quote makes it seem, but I think there's a real story here. It's a story not just of businesses' greed, but of a fundamental break in the gap between prices charged and value delivered.

Because experientially, we've all noticed that prices are going up faster than we feel they should. While we all understand inflation over the last four years has been massive, many people feel this has been taken advantage of by companies. I'm not here to argue that it hasn't, but I think there's something deeper going on.

To start, let’s look at an idealised discretionary consumer transaction. A company gives me something I value, and I give them money for that. Ideally I give them a little bit less than what I feel the value I’m getting from it is worth to me. From the company's end, the gap between how much I value the thing they're giving me and what it actually costs them to deliver it is their profit margin (however you define that).

Here's the thing: the parts of the experience that I value and how much I value them don't map cleanly onto what it costs the company to deliver. For instance, if I go to a nice restaurant, I value the experience of sitting there in a place with ambiance, with someone I care about, eating and drinking things that make me happy. Some of those things I can be charged for: eating and drinking. Others I can't, like the ambiance, the view, the attention to detail of the staff, and the care of the server. All of these things cost money for the business to deliver.

Right there, there's a gap between what delivers value to me, and what the restaurant can charge me for. It gets deeper than that. The restaurant can make different amounts of money on different parts of the meal. Food margins are notoriously tight, although some parts of the menu will have higher margins. Where they really make margin is on alcohol. A significant portion of the restaurant's margin from my visit, which funds things like the ambiance, will come from the alcohol.

This isn't unique to fine dining. McDonald's might be known for their burgers, but a significantly higher portion of their margin will come from fries and drinks.

Along with this profit structure, a key insight of the consumer goods industry over the past 50 years has been that value can be engineered. There are ways to frame or deliver products that will massively increase how valuable I feel they are. Obviously, some of this is branding, but more so how products are positioned so that I see them as doing a more important job in my life.

The classic example of this is Clayton Christensen with the Jobs to Be Done theory. It actually connects to McDonald's because he did some work with their milkshakes. He realised that consumers valued milkshakes differently on the way to work than at 3 pm because they were doing completely different jobs. On the way to work, it was something to sip on, potentially as an alternative to breakfast, that took 20 minutes of driving to finish. On the way home from work, perhaps that was something that you bribed the kids with. They're exactly the same product, but the value to you and what they deliver are quite different.

This insight drives things like size versus price points, but it also drives product innovation. You can takea $4 milkshake, keep the same costs, but frame it as an elevated drink like a frappe, and charge twice as much. In value engineering I'm really trying to juice the amount of value that a consumer perceives from the products or services they buy from me. And it's not all bad because, at the end of the day, we buy products and services to do a job for us.

Businesses are getting more sophisticated about these two things: value engineering and capturing value from different parts of the experience. It has added a lot of sophistication into consumer goods, but the downside of sophistication is that it's more brittle. Brittle systems are vulnerable to shocks. And damn, have we had some shocks over the last 20 years.

If you frame consumer welfare as value delivered, a great example is Zoom calls replacing airline flights for the section of fliers who were traditionally most price insensitive, business travellers.

Another example is a move away from alcohol. Restaurants' pricing strategies don't work if 40% of their patrons choose not to drink alcohol. McDonald's pricing strategies don't work if 30% less people choose to buy a combo with their burger because of an awareness of fats + carbs, a move to smaller portion sizes, or a percentage of the population on Wegovy.

If businesses have been relying on one portion of their offer to deliver an outsized share of their profits, and the way people buy has shifted sales away from that portion, they need to increase prices on the core part of the product to continue to make money.

Honestly, I think it’s going to get worse - both for businesses and consumers. Technology tends toward delivering the same consumer welfare at lower prices - zoom and Wegovy are great examples. AI shifts how people buy, and it’ll shift towards unbundling. All of this means less margin being made on the parts of businesses offers that traditionally subsidised the core offer. But surely it’ll lead to a rebalancing of prices towards what things actually cost, right?

What I'm reading

I've enjoyed the article The ‘Consumer Socialism’ Trap, which is particularly germane in this election cycle. While doing work on Zespri I've also come across John Knight, now retired from the University of Otago, and been looking at his work on buy local and the branding on a nation.

What I'm watching

Last night I started on the Norm McDonald documentary. It's got some phenomenal storytelling, along with getting a great look at a phenomenal storyteller. I know I've shared it before, but this week I've been diving into the 3 incredible videos highlighting Schulz Organic Dairy. Luke, the creator behind these, has done an incredible job of setting up the story and the stakes, while making you root for the indie milk producer.

Can I help?

I'm keen to be telling more stories on short form video about kiwi primary producers, particularly where they're doing cool things with selling direct to consumers. Thinking farms, honey, etc. Is this you, or is there someone you think I should talk to? Please do get in touch!

That's all from me this week,

Reuben