Adjusting Prices For Diminishing Marginal Utility

Apr 28, 2015

 

Recent examples of smart vendors understanding (and accepting) the nature of their products and discounting to offset their diminishing marginal utility.


Some vendors understand and accept the fact that their products offer diminishing marginal utility – that each unit consumed provides a little less utility than the one that came before it. These vendors discount those additional units accordingly – they tempt you to buy more by charging you less.

Move theaters offer the most extreme example of this, with medium and large sizes of popcorn and soda offering per-unit discounts of 80%-90% over the small sizes. They are sensitive to the truth that cold, congealed popcorn and warm, flat soda offer little "utility" (in this case pleasure) to moviegoers so they discount them, very heavily, in the hope that customers simply won't be able to resist the deal.

It's been going one for decades, but a recent trip to the movie theater demonstrated that they are now being even more aggressive about it. Any "idle" POS stations at the concession counter (those not actively ringing in a sale or being used) displayed this...

 

diminishing_marginal_utility_soda_01.jpg 

 

... alternating with a similar deal for popcorn. Then, during the checkout process, they kept it up – alternating between these two screens:

 

diminishing_marginal_utility_soda_02.jpg

 

diminishing_marginal_utility_popcorn_01.jpg 

 

And, of course, the attendant is also verbally encouraging you to go with a larger size. Even as you are buying the items they are making every available effort to sell you additional units that provide them with a tiny fraction of their standard margins.

Why? After making almost $5 in profit on a small popcorn or soda why would they work so hard to make just a few cents more on the upgrade to medium or large? Many retailers simply wouldn't bother for so little money.

This is often where someone points out that movie theatres do this because they can – because the staggering margins on the small size allow this kind of extreme discounting. That is the "how" they can afford to do it, but not the "why" they choose to do it, let alone do it so aggressively. After all – if you can get those margins on a small wouldn't you want to get them on medium and large sizes two?

The movie theater understands a few things:

 

  • Nobody takes margin to the bank, but every little bit of extra revenue that they can get helps.
  • Their product offers diminishing marginal utility. The first few handfuls of popcorn or sips of soda are great, the ones that follow less so. If they were to maintain their markups nobody would buy medium or large sizes and they would miss out on the chance to earn a little more money.
  • They sell a discretionary indulgence, not an essential staple. Nobody has to buy popcorn or soda, and they have no idea when the customer will be back. They want to get as much as they can out of that customer at that moment.
  • Their product is highly perishable. A customer can't buy a large popcorn or soda and stockpile it for the next time they go to the movies. There is no risk of cannibalizing future sales at high margin by offering discounts.

 

When you look at all this discounting is the only thing that makes sense. It's almost like a negotiation – they're saying "look, we know you aren't really going to enjoy the dregs of this enormous soda ninety minutes from now, and we don't if or when we'll get to sell you anything again, so we'll give you a deal so we can take a little more money to the bank. Since we know you can't save the product for next time we don't mind".

To a lesser degree other retailers may be in a similar situation. Florists for example sell a product that is discretionary and highly perishable. They don't know if/when a customer will purchase again. They do know however that someone can't buy two dozen roses , use half for a birthday that week and save the rest for Valentine's Day two months later.

Florists should offer discounted upgrades to larger sizes. If, for example, they sell a dozen roses for $60, they should offer the customer the chance to upgrade to eighteen roses at $75 or two dozen at $90.

Yes – it means lower margins and smaller profits on those extra roses. But it's profit that they would not see if they instead clung to their standard margins.

 



Category: Examples

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