A primer on airline pricing

One of the most scorned and disdained – and least understood – pricing strategies is employed by the airline industry, illustrated by this anonymously authored email about purchasing house paint, circulated in Australia where Qantas has a large share of the market:

 

First, a reprise of how ordinary hardware stores sell paint:

 

Customer  Hi. How much is your paint?

 

Salesman  We have normal quality paint for $18 a litre and premium paint for $25. How many litres would you like?

 

Customer  Five litres of normal paint please.

 

Salesman  Great. That will be $90.

 

Now, imagine you are buying paint from Qantas: First you spend days trying to reach them by phone to ask if they have paint. Nobody answers. So, you drive to a Qantas store.

 

Customer  Hi. How much is your paint?

 

Salesman  Well, sir, that all depends on quite a lot of things.

 

Customer  Can you give me a guess? Is there an average price?

 

Salesman  Our lowest price is $12 a litre, and we have 60 different prices up to $200 a litre.

 

Customer  What’s the difference in the paint?

 

Salesman  Oh, there isn’t any difference; it’s all the same paint.

 

Customer  Well, then I’d like some of that $12 paint.

 

Salesman  When do you intend to use the paint?

 

Customer  I want to paint tomorrow. It’s my day off.

 

Salesman  Sir, the paint for tomorrow is the $200 paint.

 

Customer  When would I have to paint to get the $12 paint?

 

Salesman  You would have to start very late at night in about 3 weeks. But you will have to agree to start painting before Friday of that week and continue until at least Sunday.

 

Customer  You’ve got to be kidding!

 

Salesman  I’ll check and see if we have any paint available.

 

Customer  You have shelves FULL of paint! I can see it!

 

Salesman  But it doesn’t mean that we have paint available. We sell only a certain number of litres on any given weekend. Oh, and by the way, the price per litre just went to $16. We don’t have any more $12 paint.

 

Customer  The price went up as we were talking?

 

Salesman  Yes, sir. We change the prices and rules hundreds of times per day, and since you haven’t actually walked out of the store with your paint yet, we have just decided to change. I suggest you purchase your paint as soon as possible. How many litres do you want?

 

Customer  Well, maybe five litres. Make that six, so I’ll have enough.

 

Salesman  Oh no, sir, you can’t do that. If you buy paint and don’t use it, there are penalties and possible confiscation of the paint you already have.

 

Customer  WHAT?

 

Salesman  We can sell enough paint to do your kitchen, bathroom, hall and north bedroom, but if you stop painting before you do bedroom, you will lose your remaining litres of paint.

 

Customer  What does it matter whether I use all the paint? I already paid you for it!

 

Salesman  We make plans based upon the idea that all our paint is used, every drop. If you don’t, it causes us all sorts of problems.

 

Customer  This is crazy!! I suppose something terrible happens if I don’t keep painting until after Saturday night!

 

Salesman  Oh yes! Every litre you bought automatically becomes the $200 paint.

 

Customer  But what are all these “Paint on sale from $10 a litre” signs?

 

Salesman  Well, that’s for our budget paint. It only comes in half-litres. One $5 half-litre will do half a room. The second half-litre to complete the room is $20. None of the cans have labels, some are empty and there are no refunds, even on the empty cans.

 

Customer  To hell with this! I’ll buy what I need somewhere else!

 

Salesman  I don’t think so, sir. You may be able to buy paint for your bathroom and bedrooms, and your kitchen and dining room from someone else, but you won’t be able to paint your connecting hall and stairway from anyone but us. And I should point out sir, that if you paint in only one direction, it will be $300 a litre.

 

Customer  I thought your most expensive paint was $200!

 

Salesman  That’s if you paint around the room to the point at which you started. A hallway is different.

 

Customer  And if I buy $200 paint for the hall, but only paint in one direction, you’ll confiscate the remaining paint?

 

Salesman  No, we’ll charge you an extra use fee plus the difference on your next litre of paint. But I believe you’re getting it now, sir.

 

Customer  You’re insane!

 

Salesman  But we’re now THIS COUNTRY’S only paint supplier! And don’t go looking for bargains! Thanks for painting with Qantas (R. Baker, Pricing on Purpose, 2006).

Tackling crime - augmenting the virtuous circle

Unemployment and high crime rates tend to go together. A high crime rate is a disincentive to investment, attraction of skills and a damper on tourism and, therefore, exacerbates unemployment. A high crime rate also contributes to a social breakdown and encourages the emergence of bad trends, including mob justice in all its manifestations.

Even though tackling crime is not directly part of an economic policy, because of its direct impact on economic activity it is imperative to include it in any economic proposals.

It is really an intellectual game

 Development is really, ultimately, an intellectual game. 

 

The standard prerequisites for development are well known, but the power of intellect is hardly ever mentioned, if at all.

 

The fact that intellectual capital, intellectual wealth, trumps everything.

 

The intellect of a people to choose and elect the right leaders.

 

The intellect of the leaders to choose and doggedly follow the right policies.

 

The intellect to realise and understand that, ultimately, intellect trumps everything.

 

The intellect to realise that lack of natural endowments/resources does not doom you to failure, that there are many paths to development, that in fact, in a perverse but virtuous way, lack of endowments may actually be a blessing because it frees the intellect to think creatively, to innovate, not to depend on ‘natural capital’, but to depend on abundant, perpetual intellectual capital. Or, conversely, that abundant natural resources are not a prerequisite, nor do they ensure, development and that, perversely, if unaccompanied by intellectual power may actually be a ‘curse’ for they tend to lull the mind and promote lazy thinking.

 

Give me a resource rich country, and I’ll give you a country with none but is at the top of all human and economic development indices.

 

All that is required is to free the intellect and shun lazy thinking like the plague.

Mother Teresa

Where are the Mother Teresas in South Africa? People who are in it not for the careers or the thrill of political debate, but who genuinely want to change people’s lives for the better.

People who are not only able, but prepared to walk in someone else’s shoes, especially the poor and marginalised, the wretched of the earth.

South Africa has got the means to uplift everybody out of abject poverty. At some point, the fact that it’s not happening, somebody has to own the failure, accept the blame. The billions that are squandered, whether it be through corruption or vanity or poorly conceived projects, the failure of economic policies, or policies that are wrong to begin with, somebody has to own that.

Ego trips are not going to help the people. Genuine and implementable solutions will. 

Penetration

 Penetration: The proportion of people in the target market who bought (at least once in the period) a specific brand or a category of goods.

 

 

 

Two key measures of a product’s “popularity” are penetration rate and penetration share. The penetration rate (also called penetration, brand penetration, or market penetration as appropriate), is the percentage of the relevant population that has purchased a given brand or category at least once in the time period under study.

 

EXAMPLE: Over a period of a month, in a market of 10,000 households, 500 households purchased Kill Now brand of flea killer.

 

 

 

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A brand’s penetration share, in contrast to penetration rate, is determined by comparing that brand’s customer population to the number of customers for its category in the relevant market as a whole. Here again, to be considered a customer, one must have purchased the brand or category at least once during the period.

 

 

EXAMPLE:  Returning to the flea killer market, during the month in which 500 households purchased Kill Now, 2,000 households bought at least one product of any brand in this category. This enables us to calculate Kill Now’s penetration share.

 

 

 

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Decomposing Market Share

 

Relationship of Penetration Share to Market Share: Market share can be calculated as the product of three components: penetration share, share of requirements, and heavy usage index.

 

 

Share of Requirements: The percentage of customers’ needs in a category that are served by a given brand or product.

 

Heavy Usage Index: A measure of how heavily the people who use a specific product use the entire category of such products.

 

In light of these relationships, managers can use this decomposition of market share to reveal penetration share, given the other inputs.

 

 

EXAMPLE:  Eat Wheats brand cereal has a market share in Durban of 6%. The heavy usage index for Eat Wheat cereal is 0.75 in Durban. Its share of requirements is 40%. From these data, we can calculate the penetration share for Eat Wheats brand cereal in Durban:

 

 

 

The Power of Depreciation and Amortisation

Depreciation is a prime example of what accountants call a non-cash expense[1]. Right here, of course, is where they often lose the rest of us. How can an expense be other than cash? The key to that puzzling term is to remember that the cash has probably already been paid. The company already bought the truck. But the expense wasn’t recorded that month, so it has to be recorded over the truck’s life, a little at a time. No more money is going out the door; rather, it’s just the accountant’s way of figuring that this month’s revenues depend on using that truck, so the income statement better have something in it that reflects the truck’s cost. Incidentally, you should know that there are many methods to determine how to depreciate an asset. You don’t need to know what they are; you can leave that to the accountants. All you need to know is whether the use of the asset is matched appropriately to the revenue it is bringing in.

Amortisation is the same basic idea as depreciation, but it applies to intangible assets. These days, intangibles are often a big part of companies’ balance sheets. Items such as patents, copyrights, and goodwill (to be discussed further in a later lesson) are all assets – they cost money to acquire, and they have value – but they aren’t physical assets like real estate and equipment. Still, they must be accounted for in a similar way. Take a patent. Your company had to buy the patent, or it had to do the research and development that lies behind it and then apply for it. Now the patent is helping to bring in revenue. So, the company must match the expense of the patent with the revenue it helps bring in, a little bit at a time. When an asset is intangible, though, accountants call that process amortisation rather than depreciation. I’m not sure why – but whatever the reason, it’s a source of confusion.

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[1] A non-cash expense is one that is charged to a period on the income statement but is not actually paid out in cash. An example is depreciation: accountants deduct a certain amount each month for depreciation of equipment, but the company isn’t obliged to pay out that amount, because the equipment was acquired in a previous period.

Real Options and Decision Trees

If financial managers treat projects as black boxes, they may be tempted to think only of the first accept-reject decision and to ignore the subsequent investment decisions that may be tied to it. But if subsequent investment decisions depend on those made today, then today’s decision may depend on what you plan to do tomorrow.

When you use discounted cash flow to value a project, you implicitly assume that the firm will hold the asset passively. But managers are not paid to be dummies. After they have invested in a new project, they do not simply sit back and watch the future unfold. If things go well, the project may be expanded; if they go badly, the project may be cut back or abandoned altogether. Projects that can easily be modified in these ways are more valuable than those that do not provide such flexibility. The more uncertain the outlook, the more valuable this flexibility becomes.

That sounds obvious but notice that sensitivity analysis and Monte Carlo simulation do not recognise the opportunity to modify projects. In real life, if things go wrong with a project, the company would abandon to cut its losses. If so, the worst outcomes would not be as devastating as a sensitivity analysis and simulation may suggest.

Options to modify projects are known as real options. Managers may not always use the term real option to describe these opportunities; for example, they may refer to “intangible advantages” of easy-to-modify projects. But when they review major investment proposals, these option intangibles are often the key to their decisions.