The Importance of Consumer Surplus
Why is the Happy Meal such a popular product? Why do elite brands rise to thei top of their markets? How does iPhone excel in meeting customer demand? Why do companies focus on value added initiatives? Why is proper pricing a critical but under-emphasized exercise? The answers to these questions are tied to a concept found in economics called consumer surplus.
Consumer surplus is the benefit that a person derives from a product in relation to what they pay. It is a concept that when applied to pricing methodology helps a company position what they are selling. Because economics is a social science, consumer surplus is a social science tool to help companies project the value of their product through pricing . Despite its effectiveness, it is often not considered when companies are developing their pricing methodology.
Consumer surplus is a concept that was originally solidified by economist Alfred Marshall over a hundred years ago. It delivers a framework for how companies should think about their product pricing. Consumer surplus also provides key insight into understanding how Porter’s Generic Strategies work. Understanding consumer surplus will help a business unlock how they want to implement the Generic Strategies because the strategy is actualized in the company’s pricing model. Remember, broadly speaking a company pursues a cost leadership strategy or a differentiation strategy. Ultimately, understanding the perceived consumer surplus of a product leads to the pricing methodology, which is a component in choosing a generic strategy.
Understanding how people think and feel is integral to how a company prices its products. Pricing methodology is often a mystical process, especially to small businesses. However, if a company understands the concept of consumer surplus, then it delivers a tool that adds valuable insight into product pricing. The key is to understand how consumer surplus works so that it can be used as a tool to fully optimize a company’s pricing. When pricing is optimized, this leads to a greater likelihood that profitability will be optimized.
Understanding Consumer Surplus
Consumer surplus deals with the perception that a customers has about the value of the product they are purchasing. Basically, consumer surplus is the additional benefit that a consumer receives above the cost of the product (thus the surplus component of the name). In other words, it is the perceived benefit and value that a person receives less the actual price of the product. Using a bottle of water as an example, if it costs $1 to purchase the bottle of water, but the customer receives $2 of perceived value from the purchase, then the consumer surplus for that purchase is one dollar. Ultimately, the more that a person pays, the less perceived consumer surplus they will enjoy, ultimately potentially reducing their desire to purchase the product.
Here are two examples that show how consumer surplus works. Assume that the two examples are the same product that is purchased at two different locations for two different prices, but by the same customer on the same day. Look at how consumer surplus is reduced in Example 2. In this case, the consumer had less perceived benefit from the purchase at Location 2.
LOCATION 1: $2.00 Perceived Value –> $1.00 Product Purchase Cost = $1.00of Consumer Surplus
LOCATION 2: $2.00 Perceived Value –> $1.50 Product Purchase Cost = $0.50of Consumer Surplus
Looking at the two examples above, the customer would likely purchase in either scenario, because they had excess consumer surplus in both purchases. If these two outlets were next to each other, the customer would gravitate to Location 1, but if it is not convenient, then the price at Location 2 is still a purchase scenario for the customer.
So, how can a company use this concept to maximize the pricing? It is easy to determine the value that customers have for a product by doing market research or a simple survey. Using a survey, you can look at a product from the perspective of the consumer to determine how your product is perceived in terms of value. Sampling a large enough group will enable a company to determine how much their product is worth to the consumer. Very large companies have the resources to do this and are always optimizing their prices, often by individual location.
Applying the Concept
As an example, consider the iPhone and the amount of consumer surplus the company creates for its customers. In research that was published in 2012, iPhone users were polled and valued their phone at $313.27. In comparing this to the actual pricing, Apple was charging $199 for their model at the time (with two year contract through the telephone provider). That means that there was approximately $114 of consumer surplus for the iPhone user at the time, assuming they were paying $199. For those paying less, the amount of consumer surplus increased. The research did not break down the details by model in the published results.
Additionally, in the aforementioned survey the next closest competitor was Android (a fragmented market from the manufacturer standpoint) and the average value those users assigned to their phone was a $219.99, almost $100 less in value. This article compares the iPhone 4 and the Motorola Droid X pricing and prices both at $199.99. If the prices of both are equal, but consumers view more value in the iPhone, so that means there is more consumer surplus in general for iPhone owners. When there is more consumer surplus – meaning more perceived value – then that item will outsell its competitors most of the time.
Some reports indicate iPhone sales are declining and price is generally cited as the reason. However, this is the phone in the market that every other manufacturer strives to emulate. Originally, the iPhone had a rich feature set. It is the owner’s primary phone, camera, portable computer, and iPod music player. Additionally, there are some other benefits that defy definition. Consider status as an example, especially among the early adopters. The lifestyle for those that value the brand (longtime Apply and Mac buyers); and the vast availability of accessories available for this brand. All of these items add to perceived value, which in turn increases consumer surplus.
Sometimes, odd scenarios arise that allow companies to charge more because of the lack of prior success in a product. Apple found this out also, as its iPhone 5C sales were far short of expectations. Where most companies would have found failure in the release of a new product, Apple found it could actually get away with charging more for subsequent models because of the lack of sales of a less expensive model.
This may be the reason that Apple outsells the Droid competitors on the United States, but the Droids win internationally. The varied perceptions will change the amount that a company can charge from region to region, and country to country. Because the iPhone is a product with one of the largest price tags, but also one of the most successful products in history in terms of sales, it is important to look at this product when studying pricing methodologies.
It Is Truly Mental Arithmetic
So, while no one consciously adds the benefits of a product in their mind at the time of purchase, they are subconsciously doing the math and at some point prior to purchase to establish a value for the product. Think of a time when you mulled over a purchase. As you went back and forth over the purchase on a conscious level, you were doing arithmetic subconsciously in your head. In that type of a scenario, you only purchase when the value you perceive is more than the cost. There must be consumer surplus to execute the purchase. The greater the surplus, the harder it is for the consumer to walk away from the purchase. And when devoid of surplus, people generally walk away UNLESS some other force is altering their decision-making process.
When looking at your product, think about the subconscious list that the prospective customer is adding up in their mind at purchase. Can you get the value of the perceived features and benefits above the price tag, and more importantly can you convey that message. If you can not convince the buyer, and reinforce that message continually, then you will fail to accumulate sales. Remember, it is not just making the product or service available, it is continually reinforcing the value to the customer.
Back to the generic strategies. Now that there is an understanding of why people make the purchase, let’s apply that to a chosen strategy. If you do not show value to your product, then that diminishes the consumer surplus that customers will derive, minimizing your ability to operate where you want to within the generic strategies. Consumer surplus shows us that we must continually look for ways – preferable in an inexpensive way – to increase the value of the product or service we sell.
Adding Value to Increase Consumer Surplus
The easiest way to boost the perceived value of a product is to increase the value of the product to the customer. Oftentimes, manufacturers want to reduce the quality of the product by reducing the cost of inputs. This may mean decreasing the size of the product or the packaging of the product. However, when the rest of the market is moving to decrease the perceived quality of a product, this may be the exact time that a manufacturer should be increasing the perceived value of their own product. This may allow one to improve their position and alter their generic strategy. And of course, the opposite is true. If everyone else is improving their product and moving to a differentiated strategy, then you may want to move in the opposite direction to satisfy a need.
Some believe that adding value requires someone to “sell” the features and benefits. However, no one has to “sell” individuals on the value of an Apple product. Just picking up the product sells the individual on the product. It was designed with simplicity in mind. While this might be hard to relate to food or cars, both can be drawn back to the experience. What is the experience of the restaurant? What is the experience of the service aspect of the dealership? This is what Steve Jobs hammered his company to strive to perfect. Make the experience more than just about a transaction. This will add to consumer surplus.
It is not uncommon for higher end automobile dealerships to pick up their customer’s vehicle for service. This makes more sense than making the person wait in a stale waiting room with old coffee and daytime television as the entertainment. With a pick-up service, a person does not have to take a day off of work to get their vehicle serviced. But, isn’t that a service that ANY auto service company could provide? Why does that have to belong to the high-end automotive market?
This is one example in one industry. The key to improving consumer surplus is to find ways in the industry the the company operates within to improve on the perceived value that the customer has of the company, and to do it in a way that is inexpensive. To fend off competitors and grow in a market, the company has to maximize the perceived value that a customer has about the product or service. The key for any company must be to maximize the perceived value of the product, which means that the customer will have more consumer surplus than the competitor can provide.
The following are some low cost ideas on how a company can maximize consumer surplus
Free Consulting – People are generally indecisive when they are unfamiliar with a scenario. Free consulting can remove doubts the customer may have about the product and increase consumer surplus.
Free Samples – Educate customers on other products within the company and giving extra product is a great way to increase consumer surplus.
Scheduling Service Visitations – unprompted service visitations are an excellent way to maximize consumer surplus.
Leveraging Technology – Technology does not always mean computerization and that one has to be impersonal. But it can increase productivity and minimize cost.
Availability Outside of Normal Business Hours – Service providers that are available outside normal business hours generally get to charge more. Call a plumber at midnight and you will see a differentiated rate.
Giving Out Your Cell Phone Number – The act of giving out your cell phone number is an extremely low cost for the business but large gain for the customer. Customers feel good when they have “special” access to resources.
Increase the Portion Size – Movie theaters often give a free refill on the large, but this article calls the purchase one of the most overpriced products. But hearing “free refill” gets people to spend more on an already overpriced product.
So, why do these small upgrades matter? The answer is that all of these things maximize the perceived value of a product. When you increase the perceived value of a product, you increase the consumer surplus. Consumers will only purchase a product when the amount of surplus (meaning additional benefit) they perceive exceeds the cost of the product. And the more consumer surplus a company can project, the more likely a buyer is to purchase the product.
The objective for every company is to maximize the consumer surplus that a customer perceives in their purchase. The happy meal, as mentioned at the beginning of the article, maximizes consumer surplus for two people: the parent and the child. The parent feels like they have done something to make their child happy, the one person they will do anything to make happy. And the child is legitimately happy at the time of purchase. Think about the additional benefit – or consumer surplus – that is generated in the sale of a happy meal. Few products can generate consumer surplus for two people simultaneously in the way that a happy meal can.
