Pricing, Profit and Paternalism
What do you do when you discover your most profitable customers are using your product wrong? This is a discussion on pricing, the morals of marketing and the costs of compliance.
A thought experiment
You decide to leave your corporate 9-5 job and start a simple business in short term storage. The value proposition is fairly clear: you will rent out storage space to people who need a place to leave their stuff for a few days, weeks or even up to 3 months.
You set up shop and start handing out fliers and doing some Google and Facebook ads. Business is dreadfully slow over the first few weeks, and you stare aimlessly at your email inbox, wondering whether quitting your job was the worst mistake you ever made.
One day you get an email. You made your first sale!
You can still remember the first client: a Chinese student who needs to store his belongings over summer. You make him a good deal, and he brings you back a bottle of rice spirit called baijiu at the end of summer out of gratitude. Business eventually picks up and it doesn’t take too long before you are sold out.
Starting to advertise
You are an experienced online marketer, so you connect your performance marketing activities to the backend of your system. You feed Facebook and Google information on your occupancy (so that you do not advertise locations that are full). You also keep it updated with all purchase information. This way the advertising platforms know the lifetime value of each user, ensuring that they acquire the most valuable customers for your small business.
Business is booming. Most short storage operators are not as savvy digital marketers as you are. You quickly start turning a profit and filling up your facility. Emboldened, you turn to a bank for a mortgage to buy another location. Quickly you end up with multiple venues (and mortgages to match). You are now the founder of a medium sized business, employing dozens and serving hundreds of customers.
Pricing and high lifetime value customers
After a few years of operating you notice something odd happens with each storage venue. You acquire fewer and fewer users after some time, but they are more profitable than ever! You decide to dig into your records to see if there are any insights in the data.
You quickly realise that users with the highest lifetime value are those who do not use your product as intended.
While you originally envisaged people leaving their stuff at your storage facility for a few weeks or maximum months, you now have clients who are paying to leave their belongings at your venue for years. Moreover, the longer you are in business, the greater the share of these users. Because your costs associated with these users are next to zero (you are not spending money servicing or marketing to them), you quickly understand that 80% of your profits come from them.
This is puzzling. Your pricing is not designed for long term storage. In the same way that hotels would be an extremely expensive place to stay for a year or a taxi would be expensive way to go from New York to Los Angeles. Your pricing was designed with new customers with short term needs, not long-staying repeat customers who continuously roll over their three month contracts.
Data Driven User Research
You try to understand these customers better, so you send them questionnaires, offering to raffle a $50 Amazon voucher as an incentive to reply. The good news is that they are mostly happy with your service, which is perhaps not that surprising given that they are loyal customers. Some of them are just forgetful or lazy. But often their personal stories are shrouded in sadness. Some of them unexpectedly had to leave the country due to the illness or death of a loved one and have not been able to return. Others are going through difficult divorces or convoluted legal cases. Some are even dealing with the threat of homelessness. They often have financial problems, but they are almost never late with payments, because they cannot afford to lose their belongings.
These clients are generally older and less wealthy than your first customer, the Chinese student. You look through your records, and you notice that while you were acquiring many student new customers from Facebook & Google initially, over time the advertising platforms started bringing you these older, less financially stable users. You fed the black-box algorithms information on who your best customers were and they delivered.
You consider re-architecting prices to be more “fair” to these customers, but you then realise that given your operational expenses you couldn’t really compete on price with long-term storage venues. Moreover, your revenues and profits depend greatly on the fees paid by these users. If you mess up the pricing too badly, you might not be able to pay your mortgages and employees.
So what do you do?
Do you have to do anything? Your customers seem happy with your service, even if they are struggling in other parts of life. Do you explain to them that they are overpaying? These customers aren’t idiots, they mostly know they are overpaying. But they often have so much going on at the moment, and cannot afford to move their belongings to a long term storage.
Do you kick them out by setting hard limits on how long they can leave their things at your venue? Surely that would be worse for them in the short term. Would it really help them long term? Would they appreciate it? Perhaps leaving things for years at your storage facility is a bad option, but the best of many bad options.
Do you review your pricing, and risk losing the profitability that allows you to keep the bank and your employees happy. How do you juggle your obligations to your customers, creditors and employees? Or do you instead lean into this insight and start advertising near courthouses and hospitals? Google and Facebook were already kind-of doing a version of this for you, without you even knowing it.
Lessons from the mode customer
This story isn’t really about short term storage.
Many businesses including gyms, food delivery providers, online games, casinos, short term credit providers, alcohol producers and subscription services rely heavily on repeat custom from people who are using the product or service offered inadequately (either excessively or not at all).
The mode customer goes to the gym he pays for, drinks a few beers a week and pays off his credit card on time. But some customers never go to the gym they pay for, drink multiple beers a day, pay exorbitant fees to keep their credit card balances and have dozens of forgotten online subscriptions.
Often customers are seemingly worse off for it, but businesses cannot survive without them. Is it the duty of businesses to ensure that their customers are using the products “properly”? Is it exploitative to explicitly seek out and advertise to these customers ? What is the ethical thing to do? And what if the ethical course of action undermines your livelihood and that of many others?
I wasn’t sure how to approach these questions, so I asked a few friends. They answered as follows:
Friend One: The problem seems to arise when the possibility of misuse attracts vulnerable people, which I imagine is specific to certain industries. In some cases (gambling, alcohol) I’m not sure it even qualifies as misuse in any strict sense as they’re known to cause dependency.
Friend Two: I think ethics are questionable when you have a model which is designed to make money from costs which are not clear (e.g. those sneaky subscriptions) and / or profit off of suffering of the most vulnerable (gambling, spiralling APRs on payday loans etc.)
Friend Three: The central proposition here is whether it is ethical to allow people to pay more for your product than they would do for a rival if they shopped around. There is a difference between setting out to do a good thing and people overpaying, and setting out to exploit.
The morals of marketing
My view is that it is unethical to make money from unclear or misleading pricing. Spiralling APRs, sneaky subscriptions and other misleading pricing strategies are not acceptable.
But it is ethical to sell a product that is more expensive than the “market” rate. That’s because “the market rate” does not exist, it is a distribution of prices, not a single value. I also think it’s ethical for businesses to sell to people considered vulnerable. Vulnerable people need goods and services just like everyone else, businesses shouldn’t exclude them.
The difficulties come when the person’s vulnerability is related to the product or service you are selling them. Nobody thinks a supermarket should bar an alcoholic from buying bread. But should they be sold alcohol? At what point should the man or woman at the till decide not to sell to an individual? At what point do you, as a business or service provider, decide that you know better than your customer about what is good for them?
Keep in mind, once the refusal happens, the person loses agency and the ability to decide for themselves. Even if the intent is to “protect” the individual, discrimination is often disguised in the fake paternalism of “good intentions”. Take for instance credit cards.
Protecting you from Credit Cards
Today, many Americans struggle with credit card debt. I wouldn’t be surprised if people consider credit cards as a prime example of an exploitative product. The Federal Reserve recently published a paper claiming that credit card rewards are a wealth redistribution programme from the poor and uneducated to the wealthy educated to the tune of $15bn dollars a year. Lenders have been viewed since time immemorial as exploitative and preying upon the vulnerable.
But up until the 1970s, half of Americans were completely “protected” from credit cards. Most financial institutions simply refused to offer credit to women. Lenders simply believed that they “knew better” than women with regards to their ability to repay. Some lenders viewed women as “high risk” borrowers, some simply thought it was “immoral” to lend to women lest they fall into a debt trap, given how they are the “weaker gender”.
In 1976 the New York Times wrote that:
“For example, the senior vice president of a major bank in Kansas City said that the bank would take into account, in a negative way, the fact that a married woman had small children “because if the children were sick, the wife, might have to stay home from work to take care of them.”
It was only the 1974 Equal Credit Opportunity Act (signed by President Ford, pictured above) that banned discrimination based on gender that women started getting credit cards en masse. Today women have more credit cards than men. Are they better off for it? I would argue that women having to access credit facilities outweighs the negatives of many women falling into credit card debt.
Drawing the line
I am not sure the original intent of the business is sufficient to provide guidance. I do agree intent matters, but intent is finicky. People and companies often end up in situations unintentionally. Setting out to exploit is clearly a bad thing, but I doubt a large percentage of businesses running exploitative businesses originally set out to do so. Intent (or lack of it) in itself isn’t enough to judge the appropriateness of an action.
It seems that there “should” be a line at which point business should refuse customer service. It is hard to know where to draw the line. And even if you know where to draw it, how do you implement it at scale? It’s easy to bar the neighbourhood drunk from the local pub if you are a bar owner. But how do you do that if you run an app with millions of customers? There will be false positives and false negatives in the tens of thousands. How do you grapple with that?
Western legal tradition has an established doctrine known as “Blackstone’s ratio” for dealing with false negatives and false positives. It states that:
“It is better that ten guilty persons escape than that one innocent suffer.”
If we view as “guilty” those users that use the product or service inadequately, and as “innocent” those that don’t, a crude application of Blackstone’s ratio would be:
“It is better to serve ten alcoholics than to deny one casual drinker a pint.”
This places a high value on the freedom of the casual drinker to have a pint relative to the harm caused by serving the alcoholics. This is more-or-less the Western liberal tradition, which places a strong onus on the individual to decide what is best for him or herself. Bartenders should only refuse drinks to the drunkest of patrons, those that are likely to be a nuisance to others.
The “freedom” of millions of individuals to occasionally drink pint of beer or a punt on sports should not be infringed in order to “protect” the thousands that struggle with addiction. Gambling, moneylending and drinking are perhaps viewed as distasteful and unethical, with critics advocating for onerous regulation and taxes, but outright bans are seldom called for.
This is by no means a flawless approach. It is not hard to find logical inconsistencies in how it is applied. For instance, why do most countries allow people to sell and consume hard liquor, but not marihuana, LSD or MDMA? It is hard to argue from a public health perspective that alcohol is safer than those substances. Moreover, the human costs to this tradition are high. In the United Kingdom, there were nearly ten thousand alcohol deaths due to alcohol-specific causes, which is a rate of 14.8 per 100000. This means that 1.76% of all deaths in the UK are alcohol related.
The Haram way
In Saudi Arabia, much fewer people suffer from alcoholism. In fact, only about 0.35% of deaths are alcohol related, but it is hard to find accurate statistics. This is because Islam forbids gambling, credit and the consumption of alcohol.
What these behaviours seem to have in common is that they offer a little benefit to many, but tremendous harm to a few. Islam seems to have decided that these behaviours and their commercialisation should be forbidden. The interests of a minority of potentially vulnerable individuals are placed ahead of the mode user. Translating it to Blackstone’s formulation:
“It is better that ten casual drinkers go without beer than to serve a single alcoholic.”
This places a much higher value on the potential harm caused to the alcoholic than the freedom of choice of the casual drinker.
The Costs of Compliance
Alcohol-related deaths are much lower in Saudi Arabia. But they aren’t at zero either. Legal bans enforced by state violence are insufficient to get rid of social problems like alcoholism, drug abuse, moneylending, prostitution or gambling. In fact, the American Prohibition and War on Drugs shows that the violent enforcement of such bans have negative externalities, such as an uptick in violence and organised crime.
Saudi alcohol abstinence is primarily religious and cultural, not legal. Muslims in the UK are much less likely to drink alcohol than non-Muslims, even though alcohol consumption is legal. Greece and Italy, two countries with a long tradition of alcohol consumption, have even lower alcohol related death rates than Saudi Arabia. Cultural norms can bias towards abstinence (e.g. Saudi) , moderate consumption (e.g. Greece, Italy or Japan) or excessive consumption (e.g. Belarus).
Moreover, centrally imposed restrictions can be too rigid for the realities of the world. Alcohol, gambling and moneylending are known to cause dependence in some individuals. But is the same true for eating pork? What about issuing bonds? Credit plays a different role today than when the Quran was written. Limiting people’s access to credit can place them at a severe disadvantage. Indeed, today even Saudi Arabia has a central bank. At the end of the day, individuals need to be able to make their own decisions given the necessity of circumstances. The Quran in fact recognises this:
He has only forbidden to you dead animals, blood, the flesh of swine, and that which has been dedicated to other than Allah . But whoever is forced [by necessity], neither desiring [it] nor transgressing [its limit], there is no sin upon him. Indeed, Allah is Forgiving and Merciful.
Heuristics for drawing the line
We have digressed a bit from the original moral dilemma, which is “when should you refuse your customer’s service if you suspect they are using your goods or services in a way that is detrimental to them”. I don’t think I have the answer, but here are a few heuristics I’ll follow:
Do not set out to exploit.
Add value to your customers and be diligent in understanding exactly how you add value to them.
Do not mislead in your pricing or advertising.
Empower your customers to make the best decisions.
Promote a responsible culture.
Assume your customer is an adult who is capable of making his or her own choices.