The Diaper Economy
I recently had a chance to speak with a pretty savvy pricing manager who understands the nature of demand in his business and how that demand should shape his pricing strategy. Since his firm sells business services he understands that demand for his offerings is driven by downstream factors that are largely beyond his control.
The technical term for this condition is derived demand. That is, demand for his firm’s services is derived from demand generated in downstream markets. When the rules of derived demand are in play, prices are generally inelastic. Changes in your prices will have no impact of the total demand for your products or services.
When I looked at last week’s producer price index (PPI) and consumer price index (CPI) reports, it became clear that many firms don’t get this. We all suspected that CPI would take a hit due to huge declines in oil and home prices as well as the massive discounting that retailers did during the the holidays. What caught my eye was the level of softness in a number of elements of the PPI. This implies that a significant number of firms are chasing declining demand by lowering prices – despite the fact that due to derived demand, those lower prices will do nothing other than drain revenues and profits from their industries.
The problem is that so many executives view pricing as a tactical tool – a means to try shore up demand. As a consequence, their firms don’t have defined pricing strategies that focus their actions on taking steps to limit price erosion not only for themselves but also for their industry as a whole.
My friend described this phenomena as “the diaper economy.” When I asked what he meant, he answered with a question. “If offered you a gross of diapers for $1.00, would you buy them?” My answer was actually “yes” (new additions to the Burton clan due any day now) but ordinarily it would have been “no.” His point was obvious, when demand is sidelined a low price won’t make it magically reappear. The demand that is remaining in the market is a result of real requirements and satisfying those requirements isn’t any less valuable than it has been in the past. In this “diaper economy” all your pricing decisions and competitive moves need to be oriented on this fact. In other words have a pricing strategy rather than a “rash” of undisciplined price reactions.