Monday, June 22, 2015

A Defense of Price Optimization

A Defense of Price Optimization
A while back, I heard about insurance companies using price optimization for the first time. This is when an insurance company strategically raises prices on only some of its existing customers, hoping that the price hike is not so large that the consumer picks up and leaves. The rub is that the price increase in, say, auto coverage, is not actually based on how risky that particular driver is. The higher price is based on the kind of consumer the company thinks he is: whether he's likely to shop coverage and switch if hit with an increase.

How could a company make such a prediction about a single customer? Data mining and predictive analytics, of course. One boon of the information age is that corporations now have a surprising amount of data on their individual customers: where you shop, the things you buy, and even how sensitive you are to price fluctuations.

It is a brave new world, and we are living in Ron Swanson's nightmare.

My initial reaction was that this practice is completely unfair. For one, it's kind of a ridiculous policy to punish your loyal customers who have been with you for years. Since we know it takes more time, money, and effort to acquire a new customer than to retain an existing one, enacting a policy to test the loyalty of your long-time customers seems particularly stupid.

And on some level, we believe that insurance customers who have the same risk profile should be offered the same price. We posit that if a group of drivers is likely to cost the company the same amount, on average and over time, they all ought to have the same monthly bill. It's intuitively fair.

But my behavior shows that I don't truly believe in paying the same price as everyone else: just the opposite. I actively negotiate, and at every opportunity, too. I try to lower the price on everything from my auto and home purchases down to my internet bill.

When I negotiate for a lower price, I am actively trying to create a situation in which I pay less than other customers for the same good or service. I'm creating price inequity: one guy will pay X, and I'll try to pay some fraction of that figure. We may both be equally good customers, paying on time for the same number of years, for the same services. And here I am trying to get this guy to end up paying more than me.

But I don't apologize for this. The myth of a marketplace in which all customers pay the same prices is not something I believe in or would want to operate in. I like getting a deal. I want to pay less than the next guy. I like wearing down a supplier. I sometimes will even brag about how little we paid to friends or family.

So it's hypocritical for me to think that I should be able to actively reduce my prices as much as I can (note that I am not campaigning for all customers' prices to be lowered), while suppliers shouldn't be able to raise them strategically.

If I am comfortable with the notion of customers paying different rates due to some negotiation on my part, it must be fine for suppliers to give it a go, too.  I target certain companies thinking I can get a lower price. Why shouldn't companies target certain customers in the same way?

And what is price optimization, if not a supplier trying to negotiate rates higher? It's just an offer. Customers have a chance to dispute the price increase, or to walk away. The fact that a lazy customer may not notice or even pick up the phone to defend his previous price is not the fault of the company. It's like Mike McDermott reminds us in Rounders: caveat emptor, pal.

When we frugal consumers try to minimize costs at every turn, can we fault a company for trying to maximizing profits?

We should remember that the price someone ultimately pays typically is not a static figure set ahead of time. When we say "the market" sets the price, it is not a passive thing happening in the ether. It happens via the interaction of customers and suppliers.  I exert downward pressure on prices by comparing prices, negotiating, and, when it's appropriate, leaving for another company.

Shouldn't a supplier be able to exert the same pressures? Shouldn't a small business or a corporation be able to put its knowledge of its customer base to its full use, and create the highest total profit that it can?

When I say I believe in a free market, doesn't that apply to the actions of a company as well?

I'll go ahead and step off the soap box, readers. It seems I've awoken my inner conservative this morning, with all this talk of free markets and arguments for the rights of corporations. I did switch from coffee to tea recently, so maybe that's to blame.

But I'd like to hear what you think on the matter. Is price optimization a fair market practice, or a discriminatory pricing scheme? Let's hear it in the comments.


*Photo is from meddygarnet at Flickr Creative Commons.

40 comments:

  1. It seems unfair to raise prices on customers simply because you don't believe they'll shop around. It also seems like bad business. I assume it costs more to acquire a new customer vs. keeping an old one. This seems like a practice that could backfire easily.

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    1. I hear you, Holly. That was my initial reaction to the story as well, and I agree that keeping existing customers is likely cheaper than trying to acquire new ones. (Though in researching this post I did find an interesting counter-argument: http://www.ipsos.com/loyalty/sites/ipsos.com.loyalty/files/Ipsos_Loyalty_Myth_8_Excerpt_0.pdfargument)

      The reason I think price optimization is an acceptable business practice (even if it's bad business that may drive away customers) is that individual customers regularly create price inequity via negotiation. If I'm comfortable creating a situation in which I pay less than another customer, even if we're buying the same product/service, then I think it's only fair that the supplier have the right to create that same price inequity.

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    2. Even if it's a bad practice - they almost certainly do this at every turn. Almost every year I receive new mail from companies saying that for one reason or another prices are going up and taxes are increasing, etc. etc. Last year Comcast tried to raise my bill from $185 to $215 by nickle and dime-ing every little thing on my plan. Instead I called their customer retention department and politely explained that I'd like them to cut my service. I explained to them that their recent mail trying to increase my bill by $30 was uncalled for and they no longer valued you me as a customer. Long story short he counter offered and gave me the exact same plan that I was currently paying $185 monthly for a new and improved $155 monthly... SO basically they wanted to up charge me $60 for something they could offer me for $30 cheaper than my original rate.(ironic it was the same proposed $30 increase that made them lose $30) I'll probably cancel next year anyways - the signup bonuses for new customers are too good to pass up, every 2 years I try to switch providers between Verizon FIOS, Comcast, DirectTV and Dish Network.

      Free Market = My freedom to choose, and I'm happy with that.
      -Rich

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    3. Rich, we have the exact same strategy. Moving between suppliers (or, at the very least, being willing to switch and to use that as a point in negotiations) is one of the best defenses against any tactic a supplier can use. They are trying to maximize profits, sure, but retaining a customer who is paying regular invoices is at least as an important objective for any company.

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  2. I can definitely see both sides. I think my main problem in price optimization is their perceived intent: They are banking on customers not knowing, not having enough time, not understanding, etc. to do any form of negotiating. It's not like this has been going on for a long time and people should be prepared. Since its new i think people need to know, "We're going to screw you unless you do something about it."

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    1. You're absolutely right, Luke: they're strategically picking out certain customers. Specifically, they're targeting customers who aren't sensitive to price increases. In my opinion, these are folks who don't pay attention or simply can't be bothered. To quote Rounders again, it's immoral to let a sucker keep his money.

      I think I just have an odd conservative bend this morning though. On most days, I'm arguing for consumer protections.

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  3. I still see both sides here. I worry about how/when/where these companies gather such information on people - it seems very predatory, which I'm not comfortable with. Also, they still have all of the power over their vulnerable patrons. If I try to negotiate a price decrease, they can say no, and I can leave if I want and negotiate somewhere else. If they prey on the right customers though, perhaps ones who, because of certain life circumstances, cannot switch to new companies easily, they will have no negotiating leverage and have to eat that new cost. If a company wants to give a blanket price increase, I'm much more comfortable with that than if they're data mining to try and prey on people they think will pay it. It sounds insidious.

    At the same time, as you point out, it's a "free" market, and why shouldn't they use all the data they've got to maximize profits? These people have put their info out there to be mined. In this age of smarter companies, we've got to be ready for different pricing for all individuals.

    Lastly, I'll just leave this little article here, which I read a few days ago, and seems relevant: http://consumerist.com/2015/06/18/price-tags-might-be-a-strange-150-year-anomaly-in-the-history-of-commerce/

    Thanks, as always, for the thought-provoking posts. Cheers!

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    1. Hey buddy. Thanks for the thoughtful comment. Lots of good stuff here.

      I see the business practice as strategic, rather than predatory. The difference between those two terms likely has to do with how competent you think a consumer is. I feel like the customer is a willing and competent actor: he's responsible to check his bill, to periodically shop around, and it's even his responsibility to try to negotiate discounts.

      However, I will concede that a lot of people are likely not going to do this. The reasons why are the crux of the issue. If we think they're incapable, consumers need protection.

      If we think they're capable, then they just need to wise up.

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    2. P.S. - Awesome article on the history of the price tag. I have that podcast from Planet Money downloaded but haven't listened yet. It's a possible subject for another post. Thanks!

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  4. Yeah, it is hard for the customers. Unfortunately that is the down side of business and not only for insurance companies. But I agree with other readers, there are two sides of it, and the main purpose of a business is to make profit.

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    1. True, that's the business' purpose. Personally, I am comfortable letting other customers pay more if they're not willing to defend against a price hike.

      For every dollar an insurance company can make of that customer, it's a dollar they don't have to spread out in price hikes to the entire customer base.

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  5. Well I'd say that if a company wants to do that, then they better be prepared for backlash, especially if it gets wind via social media. That is if there isn't a very good reason for the price hike. Just because won't cut it. So they can, but it may come with consequences for them. Then again, they may be so huge they don't care.

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    1. Hey there, Tonya. I had a section in the post on just that topic (customers leaving as a result of this practice) but it ended up on the cutting room floor. It just didn't flow well.

      I assume that insurance companies, with all their actuaries, have a fairly good prediction on how many customers are actually going to leave over this. That's kind of the genius on this sort of targeted price increase: they're only raising prices on people who likely won't leave.

      If they raised them across the board, there'd be a huge backlash.

      By targeting those consumers who, as least as far as the data predicts, won't even notice or care enough to do anything about it, there probably isn't much of a consequence for the company.

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  6. To me it just still seems like such a weird business practice. If you already have an established customer that is profitable for you, why try to slowly squeeze some more out of them until they get really angry?

    Obviously there must be extensive math behind this that only 1 in X people will ever complain and just assume the rate increases are normal. But it still leaves a sour taste in my mouth.

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    1. You've hit the nail on the head. Insurance companies' actuaries make their living by accurately predicting outcomes for a group of people. They're setting the price and choosing the group carefully, I'm sure, to ensure it's increasing profits even if X people leave.

      I suppose I'm in the minority who sees this as a savvy move rather than a scummy one.

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  7. The moral of the story: there is no loyalty in business. Only, "what can you do for me now?"

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    1. I hear you, Retire29. Ironically, my insurance company is one of the few I really am loyal to: I typically don't want to be penny wise with that service, as I need the claim to pay out. :)

      But for most of my suppliers (internet, phone, grocery brands), I am very happy to switch and chase the best value when needed.

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  8. In a way, companies already do this. I believe that you may see different prices online depending on store data, browsing history, etc..Also, many national retailers price items differently depending on the geographic location of their store.

    However, this move is designed to hurt loyal customers, which is scummy. Let's say you shop around for insurance, providing your data and personal history in order to get a fair quote. You choose Insurer A. over Insurer B. based on this quote. If Insurer A. then stealthily increases the price even if you have a good driving record, then the original quote is more like a bait and switch.

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    1. That's a good way of framing this, middle class. It a bit like a bait and switch (though I presume the increase would have to happen at a renewal).

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  9. Wonderful article and thoughts on the topic, as always.

    While I'm an avid fan of the free market, this type of scheme is always cooked up by giant corporate behemoths, who sometimes have a bit of an unfair advantage.

    Like most of you, I will switch services on a dime and I'm more than willing to sit on hold for 20 minutes with the loyalty department each year to work my bill down to a reasonable amount.

    However, whenever possible, I try to opt out of the presence of these schemes in my life. In many cases, a bit of research can produce a local or small business alternative. Those guys haven't even heard of "price optimization" and they wouldn't engage in the practice because losing a few customers to them means something.

    That's who I prefer negotiating with. Face to face, business owner to business owner. If I can't find a better alternative, I usually either opt out of the service completely (haven't had a TV for 8 years) or withstand the annual calls with the loyalty department - keeping them to a minimum (currently just my internet provider who gets my new "contract" taken care of each year in about 15 min).

    It's a big business world, until you start looking under rocks for the little guys. The initial bill might be a little more per month, but in my experience, they only raise the rate when it's absolutely called for (and long overdue). Plus, you get the feel-good effect of supporting family-owned, local businesses.

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    1. I like hearing that I'm not the only one who waits to talk to a loyalty department to reduce our bill for the next 12 months. :)

      For whatever reason though, I've found that the bigger the company, the better a deal I can negotiate. I suspect that part of this is due to their scale: they simply have more wiggle to play with than a small company. I also suspect that I am not as aggressive with a mom and pop shop. My emotions get the best of me, as I don't want to cut into the thin profits of a guy and with three kids he's trying to put through college someday. When it's a faceless corporation, the kid gloves come off.

      That said, I probably would feel better supporting local businesses.

      It's a quirk of my personality that I have an ax to grind with the buy local, buy small movements. I've always worked for big institutions, and now work for one headquartered in another state. So my personal experiences are shading my views on the topic, likely. I make my living from a Fortune 100, who is thankfully open to hire talent that is not local, and to send their dollars here to AZ's economy.

      Specifically regarding price optimization, I agree that this would only be the brainchild of a big company. Big data analytics thankfully haven't made their way to main street yet.

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  10. This is pretty interesting and not surprising (at least, to me). As others have said, businesses need to make a profit. If certain customers aren't going to fight a higher bill, then companies can get away with it.

    Then, as you said, we as consumers have a responsibility to check up on these things. I always check my premiums and I go back and forth between old and new statements to see what, if anything, has changed. If we don't like something, we can leave, as much of a hassle it might be.

    Honestly, it doesn't seem like there's such thing as loyalty in the market anymore, period. As consumers are looking to pay the least, or be savvier with their purchases, they're going to choose whichever option suits their particular situation the best. Businesses need to make up for that somehow (by preying on those that don't watch their money). It's disheartening, but with so many tools advising us how we can get the best deal, the landscape has changed over the years.

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    1. It's depressing, but I think you're right on about there not being a ton of loyalty in the marketplace anymore. As a consumer, I'm likely to leave a good supplier if a better one comes along, even if the old company has treated me well and service hasn't declined.

      I also like your take on the reasons why: it's easier than ever to compete suppliers in the information age. Seems reasonable that suppliers would get an edge, too.

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  11. I wonder how customers would react if they found out about the price optimization. Would people leave or just chalk it up to part of doing business.

    I always think price surges with companies like Uber and Stubhub and have declined to buy, but being subscribed to a service could be a big difference in my future choice.

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    1. That's a comparison my wife brought up, Even Steven: the surge pricing from Uber. It's a lot more transparent w/Uber than it is with a car insurance company though.

      The closest comparison I could think of would be airline tickets: where certain customers who aren't really on top of their stuff (e.g. - waiting until the last minute) end up paying a lot more for the same seat & in-flight beverages than those who plan ahead and comparison shop.

      Is that pricing structure immoral or sneaky?

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  12. I actually really like this strategy by the companies. It really puts the onus back on us as consumers to really be in control of our lives, which unfortunately many of us now expect governments and other agency's to do on our behalf. Its also a bit like salary negotiations - there's rarely a fixed salary cost for all employees, and the 'laziest' negotiators will usually get the worst deals.

    But I do get a little torn depending on which customer I picture - the savvy shopper like you vs the ignorant (or perhaps unfortunate) customer who is being taken advantage of. Probably also depends on the product or service.

    Fascinating topic DB40, really enjoyed this one!

    Cheers,

    Jason

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    1. Thanks, Jason. I'm typically of the opinion that consumers really need to be responsible for their own behavior. While I like the idea of an entity watching out for them, ultimately it's a better & more effective solution if people learn to watch out for themselves.

      The rub is that small segment of consumers who aren't lazy, per se, but actually have some limitations that might prevent them from picking out the bad suppliers.

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  13. I think it's somewhat shady, but you have a good point. We can't ask for better prices, then be made when companies we're already with try to compensate for that. Still feels greedy, though.

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    1. I agree, Abigail, and wish I'd thought of that point in the post. I'm actually contributing to the companies' need to use these sort of tactics, by negotiating down rates.

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  14. Are you actually referring to the practice of price discrimination? (ie- Getting people to pay more or less for essentially the same thing?).

    Price optimization is choosing the price that maximizes something at a single price point given a single goal (long term profitability).

    Price discrimination assumes that a company has enough information to maximize profitability across multiple price points.

    Since I actively consult on both, I think both are wonderful practices that every company should seek to do. That way I will make more money, and understand how I can get the best deals, even though I am too lazy to deal hunt or negotiate often.

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    1. Well, the way the linked stories use the term sounds more like price discrimination. The reasons why the insurance industry would prefer to call it price optimization is obvious.

      I definitely think the linked NPR story is worth a listen if you have a couple minutes.

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  15. I work for a health insurance company (all opinions are my own, of course) and I can tell you it is SO far from a free market. When I read your statement "When I say I believe in a free market, doesn't that apply to the actions of a company as well?" I immediately thought of how heavily regulated my industry is.

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    1. I work in the same industry, DC, and I completely agree: it's not a truly free market. Though, I'd say we're a lot closer to a free market than the opposite idea.

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  16. When I first heard about it, I thought it to be very unfair and shady. I also immediately called to get price quotes for my car insurance as I was up for renewal. Apparently Geico is still the cheapest. Anyways, I see your point that maybe it should go both ways as I also like to get a deal. I'm still unsure how I feel about this policy and honestly I'm not sure penalizing a loyal customer is a good thing in the end...especially if they hear about this.

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    1. I hear what you're saying, Andrew, and it has a feeling of being unfair. The irony is that this is probably happening, in general, to people who wouldn't have any idea or who wouldn't care.

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  17. I get your point, but I don't necessarily agree. The fact that there is room to negotiate in the first place just tells me that they're already gouging me. It depends on the company, too. Is there actually competition in the area? In many places in the country, at least when it comes to telecom/internet providers, there's still not. Or if there is, your other option is dial up Juno. Yeah, that happened to me once. In major metropolises where there ate options, maybe you could say this isn't unethical, but I have this creeping suspicion that it happens when there's an essential monopoly on the region, too.

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    1. You're bringing up some interesting points.

      Just because there is room to negotiate, does that mean the supplier is gouging a customer? What level of profit is acceptable? At what point are consumers getting one over on suppliers?

      I agree that in a monopoly it is a different story (and the monopoly itself is really the issue). But in the case of car insurance, I'm not aware of any situation that would be close to that: the industry is highly competitive.

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    2. The more I think about it the more shaky I am on my opinion. Because of your point; is there room for me to negotiate BECAUSE they're gouging others? Blah, I don't know! You always make me think!!
      I've never had any luck negotiating on car insurance mostly because my providers rates are so far below the norm other insurance companies tell me to just go with them because there's no way on earth they can match them. Ha.

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  18. I've noticed several of my insurance premiums going up lately. People really need to shop around to make insurance a truly competitive market. I will be spending the weekend comparing car and homeowners to find a better policy.

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  19. I work for one of the major insurance companies and haven't heard of this practice at mine, but then again I'm not the one making those decisions. What's interesting is many people don't consider the rate increases and why they happen. While you may not have had anything bad happen near you to your car or house, you have to consider what the entire nation looked like and how a storm may impact you even though it's thousands of miles away. Think about hurricane Sandy an East Coast based storm that essentially shut down a lot of New York. The number of policies in force in that city and the payouts directly correlates with your premium as they have to spread the risk in order to remain solvent. It also doesn't help that interest rates are at historical lows as many companies use the profits from investments to remain solvent and able to pay out claims as well.

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